What Are Arbitrage Mutual Funds?

An arbitrage mutual fund is a type of equity-oriented hybrid mutual fund that aims to earn returns by taking advantage of price differences in the stock market. Let’s understand what arbitrage mutual funds are, how they work, and the advantages of investing in them.

What Are Arbitrage Mutual Funds?

An arbitrage mutual fund is a type of equity-oriented hybrid mutual fund that aims to earn returns by taking advantage of price differences in the stock market. The fund manager buys shares in the cash market, where the stock price is lower, and sells the same shares in the futures market, where the price is higher. The difference between these prices can help the fund generate returns, regardless of the overall direction of the stock market, although returns are not guaranteed. When there are fewer arbitrage opportunities, the fund invests the remaining money in short-term debt and money market instruments.

Advantages of Investing in Arbitrage Funds

The following are the advantages of investing in arbitrage funds.

Reduced Exposure to Market Movements

Arbitrage funds buy a stock in the cash market and sell a futures contract for the same stock. This helps them lock in the price difference. It also reduces the effect of general market ups and downs. However, these funds are not completely risk-free.

Lower Risk of the Other Party Failing to Pay

Most exchange-traded futures contracts in India are cleared through a clearing corporation. This greatly reduces the risk that the other party will fail to meet its payment or delivery obligations.

Tax Treatment

Arbitrage funds that qualify as equity-oriented mutual funds are generally taxed like equity funds in India. They must meet the applicable tax rules, including the required equity exposure.

Liquidity

Most arbitrage funds are open-ended mutual funds, meaning you can usually buy or redeem units on any business day, and the amount you receive depends on the fund's applicable NAV.

Debt Investments During Low Arbitrage Opportunities

When there are fewer chances to earn from price differences between the cash and futures markets, fund managers may invest some of the money in short-term debt or money-market instruments to earn additional income.

Factors to Consider Before Investing in Arbitrage Funds

Investors must consider the following factors before investing in arbitrage mutual funds.

Returns

Returns on arbitrage mutual fund investments are not fixed or guaranteed as they depend on price differences between the cash market and the futures market. When price differences between these markets are narrow, these funds may earn lower returns as fewer profitable opportunities are available. They generally benefit from periods of high market volatility and trading activity, as these conditions can create more opportunities to earn profits.

Investment Horizon and Liquidity

Arbitrage mutual funds are often considered suitable for short- to medium-term investments and can be an alternative to liquid or ultra-short-term debt funds. They are generally considered for an investment period of 3 to 6 months, or up to 1 year.

Expense Ratios

Arbitrage mutual funds involve frequent buying and selling of securities, which can lead to higher transaction and management costs than liquid funds. These costs affect the returns investors receive. Therefore, investors should compare the expense ratios and returns of different funds after deducting expenses before making an investment decision.

Tax Treatment

Arbitrage mutual funds are classified as equity-oriented funds for tax purposes, provided they meet the required investment conditions. Under current Indian tax rules, gains from units held for 12 months or less are generally treated as short-term capital gains (STCG), while gains from units held for more than 12 months are treated as long-term capital gains (LTCG). The applicable tax rates depend on the current tax rules. Investors should check the latest tax provisions before investing or redeeming their units.

Underlying Debt and Portfolio Quality

The portion of the fund that is not used for arbitrage opportunities is generally invested in short-term money market instruments, government securities, or cash equivalents. Though arbitrage mutual funds are considered relatively low-risk, investors should check the quality of these debt investments. If the fund invests in low-rated or risky debt securities to earn higher returns, it may face additional credit risk. Hence, maintaining good portfolio quality is important for managing risk.

FAQs

What are arbitrage mutual funds?

Arbitrage mutual funds are hybrid mutual funds that earn returns by taking advantage of price differences between the cash market and the futures market.

Are arbitrage mutual funds low-risk?

Arbitrage mutual funds are generally considered low-risk, as their arbitrage positions are generally hedged against directional market movements, but returns are not guaranteed.

How long should you invest in arbitrage mutual funds?

Arbitrage mutual funds are generally suitable for short- to medium-term investments, usually for 3 to 6 months or up to 1 year.