Arbitrage funds

Arbitrage funds

Many mutual funds purchase equities, intending to sell them at higher prices eventually. This also serves to demonstrate how arbitrage funds work. Investors who want to profit from erratic markets without taking on too much risk typically pay attention to them. 

To maximise their returns, arbitrage funds take advantage of the price differences in stock shares between two marketplaces. 

What are arbitrage funds? 

Arbitrage funds are hybrid mutual fund strategies that seek to profit from price discrepancies between the same underlying assets in several capital market segments. Also available for investment are debt and money market products. 

Equity share mispricing in the spot and futures markets is the main focus of arbitrage funds. They frequently take advantage of the price differences between current and future securities to maximise profits. Shares are purchased on the open market by the fund management, and they are simultaneously sold on futures or derivatives markets. The difference between the cost and selling prices is the return you receive. 

Understanding arbitrage funds 

Arbitrage funds generate profits from fluctuating prices in several markets. They might, for example, purchase stock on the cash market and then sell the interest on the futures market.  

It’s because, despite how minute they can be, the most important types of arbitrage happen between these two marketplaces. Due to this reality, arbitrage funds aim to maximise the number of deals they execute annually to generate substantial returns. 

An arbitrage fund’s low risk of investment is its most attractive feature. Since the fund buys and sells securities simultaneously, the transaction is almost free of the dangers associated with long-term investments. 

How do arbitrage funds work? 

An arbitrage fund makes money by exploiting the price differences between securities on several markets. The cash market, sometimes known as the stock market, and the futures or derivatives market are the markets where arbitrage funds primarily trade. 

The securities’ present value is taken into account by the stock markets, while the securities’ anticipated future prices are taken into account by the futures market. Spot prices refer to stock market prices for securities, while maturity dates refer to future transactions specified in futures contracts. 

Factors to consider before investing in arbitrage funds 

The following is a list of things to think about before investing in arbitrage funds: 

  • Risk versus reward 

Since the fund manager is in charge of buying stocks in one market and simultaneously selling them in another, investors are not exposed to the hazards of equity exposure. Nevertheless, there are only a few circumstances where this occurs, and the cost difference is typically negligible. Due to this, the returns obtained are typical. 

  • Spending ratio 

This percentage draws attention to the fee the fund house collects instead of providing fund management services. It represents a small portion of the total assets of the fund. Daily trading by an arbitrage fund results in potentially significant transaction costs. The majority of these funds are also known to charge an exit load. If an investor redeems  units within 30 or 60 days of purchasing them, a fee will be charged. 

  • Duration of investment 

An arbitrage fund is perfect for investors who have set aside a short-to-medium time horizon (ie 3 to 5 years) for their investments. These funds are best for investors who are prepared to hold onto their investments for at least three to six months because exit loads are assessed on them. Fund results are mostly reliant on how volatile the markets are. Investors should think carefully before investing in arbitrage funds if volatility is lacking. 

  • Duties of the manager of an arbitrage fund 

An arbitrage fund’s fund manager creates profits for investors over a medium time horizon. As a result of the equity exposure, it enables him to manage the risks that volatility entails. The fund manager distributes the remaining funds among fixed assets that produce income. 

  • Taxes as required 

When it comes to taxation, arbitrage funds are handled similarly to equity funds. This means that investments held for less than a year are subject to short-term capital gains tax, assessed at a rate of 15%. 

Example of arbitrage funds 

Consider that the equity share of firm ABC trades at 1,220 USD on the cash market and 1,235 USD on the futures market. The fund manager arranges a futures contract to sell ABC shares at 1,235 USD after purchasing them on the open market for 1,220 USD. The fund manager would sell the shares in the futures market at the end of the month when the prices coincide, making a risk-free profit of 15 USD per share with fewer transaction fees. 

The fund manager enters into a long contract in the futures market, on the other hand, if he believes the price will decline. At 1,235 USD, he will short-sell the shares on the open market. To cover his position at expiration, he purchases shares in the futures market for 1,220 USD, making a profit of 15 USD. Another possibility is that the fund manager might buy an equity share for INR 100 on the Bombay Stock Exchange (BSE) and sell it there for INR 120 to earn a risk-free return. 

Frequently Asked Questions

While trying to enhance their profits, arbitrage traders also help to make the financial markets more efficient. When equal or comparable assets are bought and sold, their price differences become smaller. The lower-priced assets are bid up as the higher-priced ones are sold off. 

The benefits of arbitrage funds are: 

  • Given that these funds capitalize on short-term price fluctuations, an optimal investment horizon can range from six to 12 months. 
  • Compared to other hybrid and equity-oriented funds, arbitrage funds incur much less risk. Investors could consider investing in arbitrage funds if they don’t want to take on the additional risk associated with pure equity funds. 
  • Arbitrage funds have the same treatment as equity funds in terms of taxes. Your gains in a single investment year will be considered short-term capital gains and subject to a 15% tax. 

The drawbacks of arbitrage funds are: 

  • Payoff unpredictability 

Arbitrage funds are regarded as having poor reliability, which is one of the main reasons many investors choose not to include them in their portfolios. When the market is stable, these funds do poorly.  

When no successful arbitrage trades are available in a stable market, the fund may briefly switch to being a bond fund. The profitability of the fund may be significantly impacted as a result. 

  • High cost of investment 

The expenditure ratio, often known as the turnover ratio, is one of the most expensive costs related to arbitrage investments. These funds are exchanged often, which results in high transaction costs.  

Further raising the charge ratio, the fund houses impose an exit load for 30 to 60 days to deter investors from withdrawing their money too soon. As a result, the considerable expenses involved lower take-home pay. 

To maximise profits for investors, arbitrage funds use the price differential of equity shares between two marketplaces. These schemes’ fund managers simultaneously acquire shares on the cash market and sell them on the derivatives market.  

The finest arbitrage mutual funds’ returns can be calculated by deducting the cost from the selling price. These funds are considered hybrid since a sizable percentage of their corpus is invested in debt securities. 

With FDs, your returns are assured. The markets, however, determine how much money arbitrage funds make. FDs are frequently low-risk investing choices. However, the fact that arbitrage funds invest in equity markets makes them riskier than FDs. 

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