The Pros and Cons of Investing in Arbitrage Funds

Summary:

Arbitrage funds refer to a type of investment strategy or mutual fund where the goal is to earn profits from discrepancies in the prices of the same or similar assets that are prevailing in different markets. This blog explains the pros and cons of investing in them.

Introduction to Arbitrage Funds

Arbitrage funds refer to a type of investment strategy or mutual fund where the goal is to earn profits from discrepancies in the prices of the same or similar assets that are prevailing in different markets. Through arbitrage funds, the motive is to capitalise on the difference in the price of an asset in one market, with that in another, while also minimising risk. Even though there are a number of ways this can be done, some of the most common methods are:

• Simultaneous buy and sell: Traditionally, for an arbitrage fund, the person managing the fund purchases and sells the same asset (or an asset that is highly correlated) simultaneously in different markets. This may include buying a stock in one exchange and then short-selling the same one in another. The goal is to earn profits from the difference in prices between the two transactions.
• Risk arbitrage: This method is known as merger or event-driven arbitrage. Here, the technique is to profit from price disparities that are a result of corporate events such as acquisitions, mergers and corporate restructurings. Here, the manager buys the shares of the company that is being acquired and sells the shares of the company acquiring it.
• Statistical arbitrage: In this strategy, short-term pricing anomalies are identified by utilising statistical algorithms and models. The investor or manager relies on the use of quantitative analysis to determine when to purchase and sell the assets.
• Convertible arbitrage: Through this technique, the fund manager takes advantage of price differences between a convertible security (such as preferred stocks and convertible bonds) and the underlying common stock. Here, the fund can purchase the convertible security and then go on to short-sell the underlying common stock.

Advantages of arbitrage funds:

Arbitrage funds may appear lucrative for many investors because of many advantages, some of which are as follows:

• Lower risk: Usually, arbitrage funds are perceived to be low-risk investments in comparison to other mutual funds. The goal of profiting from small differences in prices of assets implies reduced exposure to fluctuations in the market.
• Steady returns: These are designed to help generate consistent returns and are similar to stable, fixed-income investments. This is appealing to investors who want more predictable streams of income.
• Diversification: The investor has the option to access various assets such as bonds, stocks and derivatives, which helps to achieve diversification of the fund, thereby spreading the risk across many asset classes. Poor performance of a single asset will not have much of an effect.
• Low volatility: The focus is on capitalising on small price differences, which is the risk of volatility is low, making it a good option for investors who are averse to risks.
• Hedging opportunities: Usually, arbitrage strategies can be used to hedge against wider market risks. During downturns in the market, it can help to mitigate losses.
• Tax efficiency: In most cases, arbitrage funds are more tax-efficient because they generate capital gains. These are usually taxed at lower rates than other forms of ordinary income. However, there may be exceptions, such as those depending on rules in different regions.

The cons of arbitrage funds:

Despite the benefits, arbitrage funds come with their share of disadvantages, such as:

• Limited potential for returns: Usually, these types of funds generate lower returns in comparison to other investments in equity because small differences in prices drive profit.
• Market risk: Despite the safeguards, arbitrage strategies are not immune to fluctuations in the market. Rapid changes in market conditions sometimes do result in losses.
• Liquidity risk: Investments in arbitrage funds may not be very liquid for certain bonds and assets, making it difficult to swiftly purchase or sell them. This can hamper the ability of the fund to capitalise on arbitrage opportunities.
• Management fees: Similar to mutual funds, these funds entail management fees, which can reduce profits because the overall returns are small to begin with.
• Tracking error: The performance of the fund may not always reflect the underlying asset's returns because of factors such as trading costs, expenses and the decision of the fund manager.
• Complexity: Dealing in arbitrage funds can be difficult because it involves simultaneous trading in different markets and/or asset classes. This makes it difficult for investors to fully understand the potential of the fund to generate profits.
• Limited growth potential: Because opportunities for these funds depend on inefficiencies in the market, the potential of the assets to grow may be restricted if more investors make their way into the market because competition increases.

Summing up

The use of arbitrage funds is considered to be relatively low risk in comparison to other mutual funds because the goal is to take advantage of temporary, small price differentials. This, however, does not always guarantee profits. The conditions may change swiftly and factors such as market and liquidity risk may impact returns. Investors, especially those who are just starting off, ought to be careful while defining their investment goals and tolerance for risk before putting their money in arbitrage funds. Each strategy and fund has its share of ups and downs. Fund managers with expertise are able to identify and execute opportunities in arbitrage, thereby maximising returns and reducing the chances of losses.