What are Arbitrage Funds and Should You Invest in Them?
Arbitrage funds are a type of equity-oriented hybrid mutual funds that generate returns by making use of a unique investment opportunity. Capital appreciation is the primary goal of investing in mutual funds. Many experts in the industry believe that leveraging arbitrage opportunities is the best way to achieve this goal.
Read on to know what Arbitrage funds are, how they work, benefits, risks, and if you should invest.
What are Arbitrage Funds?
Arbitrage funds are equity-oriented hybrid funds that invest in a mispricing opportunity that comes from market volatility. They are quite different from most other schemes that wait for their assets to grow in terms of value.
Fund managers utilise price differences in two market segments (cash and future) or between two stock exchanges. So, the capital gain comes from the difference between the cost price and the selling price.
The price mismatch is generally a very short-term opportunity, but it can render considerable returns with less risk. However, if there are no opportunities with regard to mispricing, the fund invests in debt and money market instruments. Nonetheless, as the price differences are tiny, the manager has to make several trades in a day to ensure decent profits.
How do Arbitrage Funds Work?
There are two arbitrage opportunities that a fund manager can utilise:
1. Price Difference between Spot and Futures markets
Before we proceed with how this mispricing works, let’s understand what these two markets are.
- Spot market: Commonly referred to as cash or the stock market, it is where investors buy or sell stocks in real-time.
- Futures market: It is a type of auction market where an investor buys or sells securities based on their future pricing. To invest in an expected future price, you will have to enter into a futures contract. On the maturity date mentioned in the contract, the transfer of securities takes place at the agreed-upon price.
2. Profit Difference between Two Exchanges
In 2018, SEBI introduced norms of the interoperability framework for trading stocks across different exchanges. Let’s say that the shares of XYZ Company are trading at Rs. 100 on the National Stock Exchange of India (NSE) and at Rs. 115 on Bombay Stock Exchange (BSE).
If fund managers spot this rare price difference, they can buy the stock from NSE and sell it on BSE at the same time. Without any risk, the fund will generate a profit of Rs. 15 per share, excluding transaction costs.
Also Read: Why Should You Invest In Top 5 Arbitrage Funds?
Benefits of Investing in Arbitrage Funds
Recently, arbitrage funds have been gaining a lot of traction due to the following benefits that they offer:
- Low-Risk Investment
Many individuals stay away from the world of mutual funds because of the risk factor. Fortunately, these equity-oriented hybrid funds offer the primary benefit of being a low-risk investment option.
Firstly, as one is buying and selling the same equity in different market segments at the same time, the investment is associated with low financial risk. Moreover, the fund does not face any long-term investment risk.
Secondly, their diversified portfolio (at least 65% in equity and a minimum of 35% in debt) helps reduce the risk further. The fund manager invests in debt when there are no mispricing opportunities, which makes the fund stable.
- Protection Against Volatility
Market fluctuation and volatility become a major disadvantage for other equity-oriented mutual fund schemes. Fortunately, volatility works in favour of arbitrage funds. When the market is unstable, there are more opportunities for price differences between cash and futures markets.
The fund manager needs to identify the right opportunity because volatility can adversely affect both markets. But if the fund manager can do that, these funds perform the best during a volatile market.
- Tax on Arbitrage Funds
Due to a higher proportion of asset allocation towards equity, these schemes are taxed as equity funds. Thus, based on the holding period, the returns will fall under the short-term capital gains (12 months or less) or long-term capital gains (more than 12 months) category.
For the first category, you will have to pay a tax on arbitrage funds of 15% (plus cess). Meanwhile, for LTCGs, you will pay a tax of 10% of your returns above Rs. 1 lakh.
Who is an Ideal Arbitrage Fund Investor?
Despite offering a low-risk investment opportunity with reasonable returns, arbitrage mutual funds in India are not ideal for all investors. The risk associated with these schemes is similar to pure debt funds, but they predominantly invest in equity. Thus, they are suitable investment options for those looking to invest in equity but have a low-risk appetite. Furthermore, if you are looking to hedge your portfolio against market fluctuations, arbitrage funds are a safe option.
Also Read: Best Low-Risk Mutual Funds
Role of Arbitrage Fund Manager
The fund manager of an arbitrage fund plays a crucial role. Here is a list of responsibilities they usually have:
- One of the primary responsibilities of these managers is to look for arbitrage opportunities to generate high returns. They take advantage of the price differences of equity shares in the cash and futures market.
- Arbitrage fund managers cautiously invest in both equity and debt instruments when arbitrage opportunities are lower. Additionally, he/she ensures that the risk factor in equity instruments is lowered by investing in large-cap and blue-chip stocks.
- They also have the responsibility of selecting the right debt instruments to invest in after considering their quality. They make sure that funds are invested in high creditworthy instruments, which will provide risk-averse investors with substantial income.
- When arbitrage prospects are bleak, they also look for favourable opportunities to invest in derivatives markets.
How to Select the Best Arbitrage Fund in India?
Check the following factors while selecting an arbitrage fund:
- Arbitrage funds are hybrid funds, so investors should select those funds which have the right combination of equity and debt instruments as per their investment goal and risk tolerance.
- One must compare the historical returns generated by these funds and compare them with their counterparts. It is advisable to select those funds that have performed well in recent years.
- Another thing to look for while selecting arbitrage funds is their consistency. A fund with consistent returns is more reliable. It gives investors hope that the returns will not be drastically low even during tough market conditions.
Things to Consider Before Investing in Arbitrage Funds
Here are some things that investors should keep in mind while investing in arbitrage funds:
- Risk appetite
One of the foremost things to consider while investing in arbitrage funds is how much it aligns with the investor’s risk appetite. Arbitrage funds invest in both equity and debt instruments which reduces the risk of investment significantly. Hence, a risk-averse individual will find these funds suitable investment options.
- Expense ratio
It is the fee levied by fund houses to manage the operational expenses of a mutual fund. It directly affects the returns earned by investors. A higher expense ratio means low returns and vice versa. Therefore, investors must do thorough market research and choose an arbitrage fund with a low expense ratio.
- Investment objectives
One must consider their financial objectives and assess whether investing in arbitrage funds will help in achieving them. If one is planning to invest for a short amount of time, then arbitrage funds might be a good option for them. It will provide higher returns than a savings or fixed deposit account and allow the fulfilment of medium-term goals. Moreover, one can also use these as a hedge against risky investments.
- Fund manager’s performance
The fund manager has complete control over the functioning of the fund. All decisions taken by him/her may influence the fund’s return prospects. It is imperative to track and analyse their past performance to see whether their strategy will help in fulfilling an investor’s financial objectives.
Risks of Investing in Arbitrage Funds
Before making any investment decision, it is crucial to know the risks that it carries. Despite offering some impressive benefits, arbitrage funds also carry the following risks:
- High Expense Ratio
As mentioned above, an arbitrage fund manager needs to make multiple trades a day to ensure decent profits, which results in high operating costs. This is why arbitrage funds have a high expense ratio.
Given that the expense ratio reduces the overall returns, investors should compare the expense ratio of various funds before making a decision.
- Unpredictable Returns
Indeed, arbitrage funds offer risk-free returns, but these are not always assured. So far, it is clear that these schemes outperform if the fund manager picks the right opportunity during a volatile market. However, when the market is stable, the manager focuses on debt instruments, which can lower your returns.
Moreover, as short-selling is illegal in India, you might earn negative returns when the market is completely bearish. In these situations, the futures market might trade at a lower cost than the cash market.
Final Word
Many investors stay clear of equity-oriented mutual funds because of their high-risk profile. But with the introduction of arbitrage funds, investors can now enjoy investing in equity and equity-related instruments at almost no risk. However, it is crucial that you understand how arbitrage funds work, the benefits and risks, and whether they are suitable for your investment portfolio.
FAQs on Arbitrage Funds
Ans: In India, only Equity Linked Savings Scheme (ELSS) mutual funds offer tax benefits. There are no tax benefits for arbitrage funds under Section 80C or any other section of the Income Tax Act. For taxation, these schemes will be treated as equity funds.
Ans: Arbitrage fund managers play a significant role in spotting mispricing opportunities and capitalising on them to generate returns. Furthermore, they also have to allocate 35% of the assets towards high-quality fixed-income generating instruments. Thus, their asset selection decision can massively impact the capital gains.
Ans: Arbitrage funds are famous for carrying low risk and offering protection against volatility. Yet, during extremely bearish conditions, the futures market may trade at a lower price than the cash market. Thus, you might obtain negative returns in the short term.
Ans: There are seven types of hybrid funds depending on investment objective and portfolio allocation. They are as follows:
– Arbitrage Fund
– Aggressive Hybrid Fund
– Conservative Hybrid Fund
– Multi-Asset Allocation Fund
– Dynamic Asset Allocation Fund
– Equity Savings Fund
– Balanced Fund
Ans: Here are some of the top arbitrage funds in India based on their 3-year CAGR in 2022:
DSP Flexi Cap Fund Direct Plan – 12.25%
Tata Arbitrage Fund Direct Plan – 5.25%
Edelweiss Arbitrage Fund Direct Plan -5.15%
Axis Arbitrage Fund Direct Plan – 5.05%
Ans: An ideal rate of interest (ROI) is a subjective number as it may differ from one investor to another. However, according to many experts, 3-year annualised returns close to 5% can be considered an ideal ROI.
Ans: Arbitrage funds are very helpful in achieving short and medium-term financial goals for investors. Hence, an ideal investment timeline of 3-6 years can be ideal for most investors.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
