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.
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.
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.
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.
Recently, arbitrage funds have been gaining a lot of traction due to the following benefits that they offer:
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
The fund manager of an arbitrage fund plays a crucial role. Here is a list of responsibilities they usually have:
Check the following factors while selecting an arbitrage fund:
Here are some things that investors should keep in mind while 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:
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.
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.
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