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What is Arbitrage Mutual Funds in India & How Does Arbitrage Funds Work
You can earn a decent return from the mispricing of equity shares in future and spot markets. An arbitrage fund works on this principle. As per several financial experts, these funds are among the enviable options to generate profit in a volatile market. All you need to do is conduct thorough research while investing your funds in equity shares. This article will help you guide in detail on how to earn stable returns from arbitrage mutual funds.
Arbitrage Mutual Funds in India
Fund managers buy and sell the shares of arbitrage mutual funds at the same time at different prices. This price difference is the return that you earn from such funds. As these equity-oriented funds create arbitrage opportunities in the financial market, they are known as arbitrage funds. However, fund managers need to make multiple trades in a single day as this price difference is usually low. So, to earn maximum returns, they conduct several trades at a time.
These funds function in a completely different way than any other mutual funds. Generally, you purchase assets and sell them when their value grows. However, in the case of arbitrage funds, when fund managers find an assured returns opportunity, only then do they invest in equities. In case there are no such opportunities, the fund is invested in debt securities or other short-term investment instruments.
Advantages of Arbitrage Funds
Here are some of the mentionable benefits of arbitrage mutual funds:
Comparatively Low Risks
As the securities in an arbitrage fund are bought and sold at the same time, the risks involved with these investments are almost equal to zero. These funds invest in highly stable debt securities when profitable arbitrage trade falls short. As a result, the risks involved in these investments are much low.
Arbitrage mutual funds are among such low-risk securities that often flourish when the market is volatile. This is because of the differences between future markets and cash rise during market instability. Stock prices usually do not undergo many differences when the market is stable.
So, investors cannot expect much price difference in such a scenario. As per the earning ratio of arbitrage funds, the difference between selling and buying prices matters a lot. So, market volatility is a favourable condition for these funds.
Despite its investment in equities, arbitrage funds are considered hybrid or balanced funds. This is because fund managers invest these funds in both equity and debt. As a result, taxation on arbitrage funds is similar to equity funds till 65% equity exposure. However, if the holding period exceeds 12 months then your gains will be taxed at the capital gains rate which is much lower than the ordinary income tax rate.
Working Process of Arbitrage Mutual Funds
Here is an example to help you understand the working principle of an arbitrage fund better:
Let’s assume, XYZ company’s equity share trades at ₹1,220 in a cash market and ₹1,235 in a future market. So, fund managers will buy this share at ₹1,220 and find a future contract to sell this same share at ₹1,235. Fund managers can earn a risk-free profit of ₹15 for each share after deducting the transaction cost by selling the share at the time when prices coincide.
However, fund managers can also opt for a long contract upon assuming a fall in the share prices in the future. In such a scenario, he will sell the shares at ₹1,235 in the cash market within a short period and buy the same shares at ₹1,220 in the future market. This will help cover his losses and earn him the same profit of ₹15.
Factors to Consider Before Investing in Arbitrage Funds
If you are planning to invest in an arbitrage mutual fund, don't miss to consider the following things before investment:
Arbitrage funds are great options to earn stable returns from your investments if invested in the right way. The difference between the spot market and the future market influences the returns of an arbitrage fund. So, you need to act wisely while buying and selling a share.
Investors with short-term financial goals can invest in arbitrage mutual funds for better returns. If you have idle cash, invest it in these funds instead of depositing it in your savings account. It will provide you with better earnings than savings account interest rates.
Arbitrage funds are a kind of emergency fund that helps you to park your own money aside for short-term needs. These funds generally perform better during market volatility as they facilitate earning from the differences in buying and selling price of the share.
An ideal investment horizon for these funds varies between 6 months to 1 year. You can also invest arbitrage funds in debt funds considering low risks during a stable market condition. However, the earnings in such investments are likely to be lower as compared to a volatile market.
Mutual funds are always susceptible to risks, and so are arbitrage funds. However, the risks involved in these funds are much low as the shares are bought and sold simultaneously. So, you can consult experienced financial advisors while investing in such funds for minimum risks.
Role of Fund Managers
Arbitrage funds help you to handle the risks of market volatility that arise due to equity exposures. You can earn profits from these funds over a medium to short time horizon. Fund managers play a major role in maximising your earnings from these funds as they are experts in assessing market conditions. They allocate your assets to such instruments that can generate fixed income.
Fund managers invest in debentures, term deposits, and zero-coupon bonds for expected returns during unstable arbitrage opportunities. High-credit quality debt securities ensure assured returns from unfavourable market conditions as well.
Another crucial factor that you need to consider while investing in an arbitrage mutual fund is the investment cost. AMCs charge an expense ratio to cover the fund manager’s fees and manage your funds. Arbitrage funds often involve a higher investment cost as it goes through frequent trading options. Moreover, AMCs also exert exit loads (a certain fee) in case you make an early exit.
Mutual funds, in general, come with associated risks where the profit tends to fall due to a market downturn. However, arbitrage fund is a bit different. Instead, they are designed to earn maximum returns when the financial market is volatile. You can try investing in an arbitrage fund to earn a reasonable profit amid market volatility.