Arbitrage Funds are mutual funds that take advantage of price differences in the money and derivatives markets to generate profits. The profitability of such a fund depends on the volatility of the securities market. These funds are inclusive of different entities because they provide exposure to most of the portfolios in debt markets.
Arbitrage mutual funds are an excellent option for investors looking to make money in volatile markets without taking too much risk. While the associated risk is low, the returns in payoffs can be unpredictable.
Buy here, sell there – Arbitrage funds basics
Most mutual funds are a collection of stocks that can turn in high profits on their sale during a price rise. Although it is a type of mutual fund, arbitrage funds do not follow the same strategy as general mutual funds. They are an attractive bet for investors who want to take advantage of volatile markets without taking too much risk.
Arbitrage mutual funds benefit from the price pressures of various markets. Arbitrage funds can include buying shares on the foreign exchange market and then selling them on the futures market. This happens because the main form of arbitrage occurs between these two markets, although limited. Resultantly, these funds have to trade a lot each year to make big profits.
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Arbitrage funds are taxed like equity funds. Investors need to watch expense ratios, which can be substantially high carefully.
Overview of arbitrage funds
Inter-exchange trades
Suppose the shares in ABC company cost Rs. Rs 1,000 per share on the Bombay Stock Exchange (BSE). The same company’s shares cost Rs 1,010 per share on the National Stock Exchange (NSE). If the fund manager of an arbitrage fund identifies this opportunity, s/he can buy shares from the BSE and simultaneously sell them on the NSE. From there, they can earn an Rs. 10 profit at low transaction cost and no virtual risk.
Transactions between the cash and futures markets
Assume that ABC’s shares are traded for Rs. 1,000 per share in the money (cash) market and Rs 1,015 in the futures market. In such a case, the arbitrage fund manager may buy shares in the money market and enter future contracts to sell the shares for Rs. 1015. They can sell the shares on the futures market at the end of the month and earn Rs. 15 at low transaction costs and no risk.
Benefits
Low risk
Arbitrage funds generally pose a low risk to investors. There is no long-term investment risk as shares are bought and sold in one go. Volatile markets have the most potential for profits as well as losses. It depends on how you act on your trade and your risk appetite regarding investment in arbitrage funds. These funds are a good choice for prudent investors who want to take advantage of a volatile market but not take too much risk.
Tax treatment as equity funds
While investing primarily in stock equities, arbitrage funds are a mixture of funds as they leverage the benefits of both debt and equity investments. Therefore, they are treated as equity funds for taxation as long equity showcases an average of at least 65% of the investment portfolio. Holding an arbitrage fund for more than a year brings it under the tax bracket of capital gains, significantly lower than the ordinary income tax rate.
Drawbacks
Unexpected payoff costs
The main disadvantage of arbitrage funds is their low credibility. If markets are constantly stable and smooth, investment in arbitrage funds is not much profitable. When arbitrage profit is insufficient, the fund may temporarily become a bond fund.
High Expense Ratios
Successful financing of an arbitrage fund transaction requires additional trades, representing a remarkably high percentage of your costs. In times of volatility, arbitrage funds are high yielding in nature. However, due to their mediocre reliability and substantial expenses, these should not be the only type of investment in your portfolio holding.
Are arbitrage mutual funds the right choice for you?
Debt funds and arbitrage funds have a similar risk profile. Many fund companies use liquidity metrics as the benchmark for their fund. Arbitrage is ideal for investors who want to invest in stocks but do not want to take the risk. In volatile markets, many speculative investors can make money by investing their money in an arbitrage fund.
Words of wisdom
Investing based on your capacity and plan is very important. Investment in arbitrage funds takes three to five years to create a reasonable return. Most arbitrage funds have withdrawal fees, and you should consider this before investing. These funds thrive in turbulent markets. Therefore, it is recommended to invest in a lump sum instead of a structured investment plan. When the market is volatile, investing in cash can yield significant returns.
You can invest the money in an arbitrage fund instead of putting it in a regular savings account. This way, you get the most out of your savings. However, if you have already invested in stocks, you can systematically transfer stocks from private equity to arbitrage. While this might cut down the returns, the risk can be brought down significantly.
Unlike other funds, arbitrage mutual funds place large orders and invest in distributing similar stocks in different markets. This allows investors to take advantage of market volatility without undue risk. In the end, it is best to talk to a financial professional about how an arbitrage fund would fit your investment plan before leaping.
