Arbitrage Funds are Hybrid Mutual Funds that seek to exploit arbitrage opportunities for the same underlying asset in different capital markets. Arbitrage refers to taking advantage of price differentials of the same asset, such as in the spot and futures markets.
A spot market is a place where buyers and sellers agree to a price for an asset and exchange the asset for cash at that moment. In contrast, in a futures market, buyers and sellers agree to a price for an asset at a future date. This means that they are entering into a contract to buy or sell the asset at a specified price on a specific date in the future.
Spot prices are determined by supply and demand in the present moment. In a futures market, the price of an asset is based on the expected supply and demand in the future.
Arbitrage Funds can trade in equities, debt, and money market instruments. However, they must buy and sell the same asset quantity in two different markets simultaneously to take advantage of the price differential.
According to Securities and Exchange Board of India guidelines, Arbitrage Funds must invest at least 65% of their funds in equities. They are also taxed as equity instruments.
How Do Arbitrage Funds Work?
Arbitrage Funds buy and sell the same quantity of an asset in two different markets and pocket the returns from the price differential. They work on the principle that markets are not entirely efficient, resulting in price differences in different markets.
Let’s understand with an example. Say a share of X company is trading at Rs 1,000 in the cash market. Futures markets usually carry a premium. So, the price of the same security could be at Rs. 1,030 in the futures market.
You could buy shares of X company in the cash market at Rs 1,000 and sell it at the futures market for Rs 1,030. Now there are three different scenarios that can play out. The price of the share goes up to Rs 1,100 on the date of expiry of the futures contract. You would then make a profit of Rs. 100 in the cash market and a loss of Rs. 70 in the futures market. Net-net, you still make a profit of Rs. 30.
If the price of the share goes down to Rs. 900, then you lose Rs. 100 in the cash market but make Rs. 130 in the futures market. Your profit is Rs. 30 per share again. If the prices do not change at all, you still make Rs. 30 in the futures market. This is exactly what arbitrage funds do. They take advantage of price differentials in different markets to come up with a scenario to earn profit.
Benefits of Arbitrage Funds
1. Arbitrage Funds have virtually no price risk. The equity exposure of these funds is wholly hedged.
2. Counterparty risk is also eliminated when you invest in Arbitrage Funds because the exchange guarantees settlement.
3. Arbitrage Fund can make substantial gains by taking varying positions in the cash and futures markets when the markets are volatile.
4. Despite being Hybrid Funds, they are taxed as equities.
Things to Consider Before Investing
1. Risk
While Arbitrage Funds may not have price or counterparty risk, funds that invest in debt instruments may be subject to credit risk. Moreover, Arbitrage Funds may not perform well in bearish markets because futures may trade at a discount to cash prices.
2. Return
Arbitrage Funds provide reasonable returns. They are suitable investments if you want to make money in the short- to medium term. However, much like other market-linked instruments, there is no guarantee of profit.
3. Investment Horizon
Arbitrage Funds are best suited to investors with an investment horizon of 3-6 months.
4. Investment Amount
It is better to invest in Arbitrage Funds through a lumpsum amount rather than Systematic Investment Plans.
5. Scheme Offer Document:
Before investing in an arbitrage fund, it's important to read the scheme offer document carefully. The document contains important information about the investment objective, investment strategy, risks, asset allocation, and fees associated with the fund.
6. Asset Allocation:
As mentioned earlier, arbitrage funds invest in a combination of equity and debt instruments. It's important to understand the asset allocation of the fund and how it aligns with your investment goals and risk appetite.
7. Management Fees:
Like all mutual funds, arbitrage funds charge a management fee for managing the fund. This fee is charged as a percentage of the assets under management and is deducted from the returns generated by the fund. It's important to understand the management fee charged by the fund and how it affects your returns.
Conclusion
In summary, investing in an arbitrage fund can be a suitable option for investors looking for a low-risk, moderate-return investment. However, it's important to carefully consider the investment objective, asset allocation, management fees, risks, and track record before investing in an arbitrage fund. If you have any doubt regarding arbitrage funds, be sure to talk to your financial advisor for more clarity.
Disclaimer
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
