Advantages and Disadvantages of Investing in Arbitrage Funds

Arbitrage funds are equity-oriented hybrid mutual funds that aim to generate returns by capitalising on the price differences for the same asset between the cash market and the derivatives market.

Let’s explore the advantages and disadvantages of arbitrage mutual funds.

Advantages of Investing in Arbitrage Mutual Funds

The following are the advantages of investing in arbitrage mutual funds.

Low Risk Through Market Neutrality

Arbitrage funds aim to reduce the impact of stock market movements by buying shares and selling related futures contracts. This strategy helps offset some of the impact of price changes in the two positions. However, returns are not guaranteed, and market changes, trading costs, and liquidity issues can still lead to losses.

Tax Benefits

In India, arbitrage funds that qualify as equity-oriented funds are taxed under the tax rules applicable to equity-oriented mutual funds. Short-term capital gains on units held for 12 months or less are generally taxed at 20%, while long-term gains are taxed at 12.5% on eligible gains exceeding ₹1.25 lakh in a financial year. In comparison, bank fixed deposit interest is generally taxed according to the investor’s income tax slab.

Opportunities During Market Volatility

Market fluctuations can create price differences between stocks and their related futures contracts, giving arbitrage funds opportunities to earn returns. However, higher volatility does not always mean higher profits. Returns depend on available price differences, trading costs, and market conditions.

Managed Market and Credit Risks

Arbitrage funds trade through regulated exchanges, where clearing corporations help manage settlement risks. However, this does not eliminate all risks, including market and operational risks. Funds may also invest in debt instruments, which can carry credit and interest-rate risks.

Suitable for Short-Term Investments

Arbitrage funds may be an option for investors looking to invest surplus money for a few months. They generally allow investors to redeem their units on business days, subject to the scheme’s redemption terms and applicable restrictions. However, returns are not guaranteed, so investors should compare the risks, costs, and redemption terms with those of liquid funds and bank deposits.

Disadvantages of Investing in Arbitrage Mutual Funds

The following are the disadvantages of investing in arbitrage mutual funds.

Poor Performance in Stable Markets

Arbitrage funds depend on price differences between stocks and their related futures contracts. When these differences are small, the funds may earn lower returns after expenses. Their returns may be lower than those of fixed deposits or savings accounts during such periods.

High Expenses and Trading Costs

Arbitrage funds frequently buy and sell stocks and futures contracts to benefit from price differences. Brokerage fees, transaction costs, and fund management expenses can reduce the returns investors receive. The impact of these costs depends on the fund and its trading activity.

Fewer Profit Opportunities

When more investors use arbitrage strategies, price differences may become smaller as markets become more efficient. This can make it harder for fund managers to find profitable opportunities. As a result, the fund's returns may decrease.

Execution and Pricing Risks

Arbitrage funds use related investments to reduce exposure to market movements, but the price relationship between them can change unexpectedly. Delays in buying or selling can also affect the expected profit. These risks may reduce returns or lead to losses.

Exit Loads

Some arbitrage funds charge an exit load when investors redeem their units within a specified period. The period and charges vary by scheme, so investors should check the fund's terms before investing. Exit loads can reduce returns for those who withdraw their money early.

No Guaranteed Returns

Arbitrage funds are market-linked investments, so their returns are not fixed or guaranteed. Although they generally have lower exposure to stock market movements than many equity funds, they can still incur losses. Actual returns depend on market conditions, trading costs, and available arbitrage opportunities.

FAQs

What are arbitrage mutual funds?

Arbitrage funds are mutual funds that aim to earn returns from price differences between stocks and their related futures contracts.

Are arbitrage funds safe for investment?

Arbitrage funds generally have lower exposure to stock market movements than regular equity funds, but they are not risk-free, and returns are not guaranteed.

How are arbitrage funds taxed in India?

Arbitrage funds that qualify as equity-oriented funds are generally taxed under equity mutual fund rules, where the tax rate depends on how long you hold your investment and the applicable tax laws.