What is arbitrage fund?

Arbitrage funds are a type of mutual fund which is appealing to the investors who wish to profit from volatile markets without taking on too much risk. Before investing in one, it is important to understand how they work and if they suit the investor’s portfolio. Arbitrage funds work by exploiting the price differential between the cash and future markets. Rather than purchasing stocks and selling them later after the price has gone up, an arbitrage fund will purchase stock in cash market and simultaneously sell the interest in futures market. The difference between stock prices and future contracts are marginal, so arbitrage funds will execute a large number of trades every year for making substantial gains. If an investor aims to buy on dips and sell when the markets are at high levels, they can always invest in dynamic funds.

The futures market is different since it is a derivatives market. Instead of futures contracts being valued based on the current price of the underlying stock, they reflect the anticipated price of the stock at some time in the future. An arbitrage fund works on mispricing of equity shares in the spot and futures market. It exploits the price differences between current and future securities for generating returns. Fund managers simultaneously buy shares in cash market and sell it in the future or derivatives market. Difference in cost price and selling price is the return an investor earns. Funds will leverage the market inefficiencies for generating profits for investors. The fund manager will allocate the remaining assets in fixed income generating instruments. They ensure that investment is made only in high-credit quality debt securities like zero-coupon bonds, debentures and term deposits. Helps to keep fund returns in line with expectations.

Some of the benefits of Arbitrage funds are:

1.      Low risk:

One of the benefits of arbitrage funds is that they are low risk, since each security is bought and sold simultaneously, there is virtually no risk involvement with long term investments. Arbitrage funds invest part of their capital into debt securities that are typically considered highly stable. If there is shortage of profits, funds invest more heavily in debt. This make the fund appealing to investors who have a low risk tolerance.

2.      Taxed as equity fund:

Even though an arbitrage fund is technically balanced or considered hybrid funds as they invest in both debt and equity, they invest primarily in equities by definition. They are taxed as equity funds since long equity represents at least 65% of the portfolio on average. If an investor holds their shares in an arbitrage funds for more than a year, then any gains they receive are taxed at capital gains rate, that is much lower than ordinary income tax rate.

3.      Volatility:

An arbitrage fund is some of the only low-risk securities that actually flourish when the market is highly volatile. Since, volatility leads to uncertainty among investors. Differential between cash and futures markets is exaggerated. Highly stable markets mean individual stock prices not exhibiting much change.