All about Arbitrage Funds!

If an investor wants to earn something from a volatile market, then where should they invest? Mutual fund offers arbitrage funds, which is a type of hybrid fund that assists investors to earn through volatility.

An arbitrage fund is a type of mutual fund that leverages the price differential in the cash and derivatives markets to generate returns. The returns are dependent on the volatility of the asset. These funds are hybrid in nature as they have the provision of investing a sizable portion in debt markets. The simultaneous purchase &and sale of an asset in order to make a profit from the difference in price is known as arbitrage.

Arbitrage funds are the solution for low-risk taking investors. In a situation of high and persistent volatility, arbitrage funds provide investors with a safe avenue to park their hard-earned money. These funds capitalize on the market inefficiencies and generate profits for the investors. As these funds invest predominantly in equities, their tax treatment is at par with equity funds.

How do arbitrage funds work?

Let’s assume that the equity shares of ABC Ltd is trading at Rs 1,000 and Rs 1,050 in the cash market and futures market, respectively. So, the fund manager purchases the shares of ABC Ltd at the rate of Rs 1,000 and arranges the contract to sell the shares at Rs 1,050. Here, towards the end of the month, when the prices match, then fund managers sell the shares in future markets and book the profit of Rs 50 per share while any cost involved will get deducted. On the contrary, if the fund manager thinks that the price in future is going to fall, then he can enter into a long contract in the futures market.

The fund manager will then sell shares in the cash market at Rs 1,050 while at expiry, he purchases the shares at Rs 1,000 and makes a profit of Rs 50. Fund managers also take the benefit of the same equity share trading at different price levels on BSE & NSE. Let us assume that the stock of the company - EFG Ltd is trading at Rs 60 at NSE and the same stock is trading at Rs 55 on BSE. So, in this case, the fund manager will buy the stock on BSE at Rs 55 and simultaneously, sells the same at Rs 60 on NSE.

In this, the fund manager makes a risk-less profit of Rs 5 per share out of the differential in prices in different markets for their investors. These funds perform well when the market is highly volatile.

Things to consider before investing in Arbitrage funds

Risk factor: These funds are less risky than other equity-oriented funds. As we have seen in the above paragraphs, fund managers try to generate alpha for their investors. Investors should invest in these funds according to their needs and goals.

Returns: Returns are not as exceptional as other equity-oriented funds. One-year returns of these funds vary around 3 per cent-4 per cent while 5-year returns vary around 5 per cent-6 per cent.

Cost: These funds incur fees i.e. expense ratio, which is a percentage of the fund’s overall assets. These funds include fund manager’s fees, fund management fees, etc. Due to regular trading, the transaction cost is also incurred.

Investment horizon: Investors having short-term or moderate-term investment horizons should invest in these funds. Short-term means investment horizon of at least 3-6 months while medium-term includes horizon of at least of 3-5 years.