What are Arbitrage Funds?

Arbitrage funds have emerged as a popular investment option for investors seeking stable returns with relatively lower risk. These mutual funds generate returns by using arbitrage opportunities in different segments of the market.

Arbitrage refers to the simultaneous buying and selling of the same asset in different markets to profit from temporary price differences.

In India, arbitrage mutual funds are often considered an alternative to traditional debt products, especially for investors looking for tax-efficient short-term investment options.

This article discusses what arbitrage funds are, how they work, their features, advantages, and disadvantages.

What are Arbitrage Funds?

Arbitrage funds are a category of hybrid mutual funds that generate returns by exploiting price differences of the same security across different markets. The fund manager simultaneously buys a stock in one market and sells it in another market where the price is higher. This process is known as arbitrage.

Arbitrage mutual funds primarily invest in equity and equity-related instruments while hedging their positions through derivatives. Since the equity exposure is fully hedged, the overall risk is lower than that of traditional equity mutual funds.

For taxation purposes, arbitrage funds are treated as equity-oriented mutual funds because they maintain the minimum equity exposure as prescribed under regulatory guidelines.

Also Read: What is Hedging in the share market?

How do Arbitrage Funds Work?

Arbitrage funds identify pricing inefficiencies between the cash (spot) market and the futures market. The fund manager simultaneously executes buy and sell orders to lock the price difference, which represents the profit.

Example:

Shares of a company X are trading at ₹1,000 in the spot market while its futures contract is available at ₹1,020. The fund manager buys the stock in the cash market and sells the futures contract in the derivatives market.

Upon the contract’s expiry, the price difference between the two positions becomes the fund’s return, after accounting for applicable expenses and transaction costs. The process is repeated across multiple securities, allowing the fund to build a diversified arbitrage portfolio and generate relatively stable returns while minimising market risk.

Steps Involved in Arbitrage Investing

Here are the 5 simple steps involved in arbitrage investing:

• Identification of stocks:

Fund managers identify the stock which have temporary price differences between the cash and derivatives markets.

• Simultaneous Transactions:

The same security is bought and sold simultaneously in different market segments.

• Profit Locking:

The price spread gets locked, reducing exposure to market fluctuations.

• Position Settlement:

On the expiry of futures contracts, profits are realised from the captured spread, and the settlement is done.

• Portfolio Diversification:

Multiple arbitrage opportunities are utilised across various stocks and sectors.

Features of Arbitrage Funds

Here are the key features of Arbitrage funds:

• Low Risk Profile:

Hedged equity positions help reduce the impact of market volatility, resulting in relatively lower risk compared to pure equity funds.

• Equity Taxation Benefit:

Arbitrage mutual funds enjoy equity-oriented taxation advantages under prevailing tax regulations.

• Short-Term Investment Suitability:

These funds are generally suitable for investors with an investment horizon of six months or more.

• Professional Fund Management:

Experienced fund managers identify and execute arbitrage opportunities efficiently to generate returns.

• Market Neutral Strategy:

Returns mainly depend on arbitrage spreads rather than market direction.

• High Liquidity:

Investors can redeem units easily, subject to applicable exit load provisions.

• Diversified Exposure:

Investments are spread across multiple arbitrage opportunities, helping to minimise concentration risk.

• Lower Return Volatility:

Returns tend to be more stable compared to traditional equity mutual funds due to the hedged nature of the portfolio.

Arbitrage Funds vs Liquid Funds

Arbitrage funds and Liquid funds serve different purposes. Arbitrage mutual funds may be suitable for investors seeking better post-tax returns over a short period.

Liquid funds are good for building an emergency fund and meeting immediate liquidity requirements.

Here is the difference between Arbitrage funds and Liquid funds:

Factors To Consider Before Investing in Arbitrage Funds

Here are some important factors that every investor should consider before investing in arbitrage funds.

• Investment Horizon:

Investors should ideally remain invested for at least six months to maximise the benefits of arbitrage opportunities.

• Tax Implications:

Understand the taxation of equity mutual funds before investing.

• Expense Ratio:

A higher expense ratio can reduce the net returns generated from arbitrage opportunities.

• Exit Load Structure:

Review applicable exit charges for early redemption.

• Market Opportunities:

Returns depend significantly on the availability of arbitrage spreads.

• Fund Performance Consistency:

Carefully analyse the fund’s historical performance across different market cycles.

• Liquidity Requirements:

Ensure that the investment tenure aligns with your liquidity needs and objectives.

Who Should Invest in Arbitrage Funds?

Arbitrage funds can be suitable for a variety of investors depending on their financial goals and risk tolerance. Here are the types of investors who can consider investing in it.

• Conservative Investors:

Individuals seeking relatively stable returns with limited market risk exposure.

• Short-Term Investors:

Investors with investment horizons ranging between six months and one year.

• Tax-Conscious Investors:

Individuals looking for tax-efficient alternatives within mutual funds.

• First-Time Mutual Fund Investors:

Beginners preferring lower volatility investment options.

• Investors Avoiding Debt Risks:

Individuals seeking alternatives to traditional debt-oriented products while maintaining a relatively conservative risk profile.

How should you invest in an Arbitrage Mutual Fund?

You can invest in arbitrage mutual funds directly from the AMC website or through a SEBI-registered broker like Upstox.

To invest in arbitrage mutual funds through Upstox, you need to open a demat account. However, if you already have a demat account, you just need to follow the instructions below:

• Open the Upstox mobile app
• Navigate to the mutual fund section
• In the search bar, type arbitrage funds
• Analyse the list of various arbitrage funds
• Choose any one that suits your goals
• Select one-time buy or SIP
• Enter the amount
• Place the order

Advantages of Investing in Arbitrage Funds

Here are a few advantages of investing in arbitrage funds:

• Lower Market Risk:

Hedged positions minimise the impact of sudden market fluctuations and reduce overall portfolio risk.

• Equity Tax Benefits:

Investors can enjoy taxation advantages associated with equity-oriented mutual funds.

• Better Returns:

Returns may exceed those of traditional savings products and certain debt instruments under favourable market conditions.

• Professional Management:

Expert fund managers identify and execute arbitrage opportunities efficiently.

• Diversification Benefits:

Exposure across multiple securities and arbitrage opportunities helps reduce concentration-related investment risks.

• Suitable for Short-Term Goals:

These funds are suitable for investors with moderate short-term investing objectives.

Disadvantages of Investing in Arbitrage Funds

Here are a few disadvantages of investing in arbitrage funds:

• Moderate Return Potential:

Returns may not match the long-term growth potential of equity mutual funds.

• Dependence on Market Spreads:

Limited arbitrage opportunities can affect return generation.

• Exit Load Restrictions:

Early redemption may attract exit charges, depending on the fund's terms and conditions.

• Complex Investment Strategy:

The arbitrage mechanism may be difficult for beginners to understand.

• Variable Returns:

Returns are not fixed and may fluctuate based on prevailing market conditions.

• Not Ideal for Long-Term Wealth Creation:

The growth potential of arbitrage funds remains lower than that of diversified equity funds.