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.

What is a good P/B ratio?

A P/B ratio of less than 1 is good, meaning that the stock is undervalued, and stock price is trading at a lower price as compared to the value of the company’s assets that is neglected by the market. This can be a potential buying opportunity, but it must be researched carefully.

A P/B ratio higher than one means it is an expensive stock. This can happen due to two reasons :

First: The investors believe that the market conditions will turn favourable to the business which can give better returns. This anticipation makes investors pay more than the book value and thus drives the market value more than the book value. 

Second: The book value of the company might not be updated. For instance, a company’s balance sheet might reflect the amount paid for an asset, but that does not mean the worth of the asset. However, in the case of assets like land whose value increases over time, the true book value becomes higher. 

Comparison of P/B ratio with others 

Usually, investors while valuing a company consider the P/E ratio, as there is a tendency of investors to gauge the returns while estimating a company’s long-term earning potential. Earnings are what is left for shareholders once all expenses are paid. The P/E ratio compares a company’s share price with its future earnings potential, while the P/B ratio is computed by comparing a company’s stock price with its assets and liabilities. A P/B ratio should be looked at from the context of the return of equity. Return on Equity is the ratio between an organisation’s equity and net income. Therefore, a company with higher RoE (return of equity) will always command a higher P/B ratio and vice versa. However, the stock is overvalued if it gives low RoE and has a high P/B ratio.