What is an Arbitrage Fund? Is it suitable for short-term investments for you?

What is an Arbitrage Fund? Is it suitable for short-term investments for you? | Vrid

In recent times, you’ve probably heard the term “Arbitrage Fund” thrown around a lot. But what is it? Can this fund help you grow your money?

While the term may sound complex, fear not – we’re here to break it down into simple, digestible chunks, explaining how they work, their historical performance in India, and the pros and cons of investing in them. And then, you can decide if this fund is right for you.

Estimated read time: 3 minutes and 37 seconds

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Buckle up. Here we go!

What is an Arbitrage Fund?

Volatility is a part of the market. Sometimes it’s high, and sometimes it’s low. Often, this volatility gives rise to some inefficiencies in the market, like the difference in the price of an equity share in two exchanges. Many investors try to leverage these inefficiencies to make some money.

Arbitrage Funds are a type of hybrid mutual fund designed to capitalize on price discrepancies in the financial markets. These funds primarily invest in two different but related instruments – stocks and derivatives (usually futures and options).

A majority of 65% or more of the portfolio of arbitrage funds is invested in equity and equity-related instruments. The balance of 35% of the portfolio is invested in debt or money market instruments. For fund categorization purposes and tax purposes, arbitrage funds are equity funds.

Investors looking for low-risk and debt-like returns can consider this category with an additional benefit of tax treatment, like equity.

How does an Arbitrage Fund work?

To understand how an Arbitrage Fund operates, imagine this scenario:

The equity share of a company ABC trades in the cash market at ₹100 and in the future market at ₹105. The fund manager buys ABC shares from the cash market at ₹100 and sorts a futures contract to sell the shares at ₹105. Towards the end of the month, when the prices coincide, the fund manager will sell the shares in the futures market and generate a risk-free profit of ₹5 per share, less the transaction costs.

In another scenario, the fund manager may purchase an equity share for  ₹100 on the National Stock Exchange (NSE) and sell the same at ₹102 on the Bombay Stock Exchange (BSE) to generate a risk-free return.

The crux of the matter is that Arbitrage Funds thrive on volatility. As the stock prices fluctuate, the fund manager makes profits by exploiting these price gaps.

It’s essential to note that Arbitrage Funds aim for minimal risk exposure by maintaining a “hedged” position in the market. This means they take equal and opposite positions in the cash and derivative markets to ensure the net exposure is minimal.

Historical performance of an Arbitrage Fund in India

To understand whether the arbitrage fund is a good fit for your portfolio, it’s essential to examine its historical performance. Keep in mind that past performance is not indicative of future results, but it can provide some valuable insights.

As of October 18, 2023, arbitrage funds (direct plans) have delivered 7.44% in the last year. Their 3, 5 and 10-year annualized returns are 5.20%, 5.43% and 6.56% p.a. (Source – AMFI)

And, as arbitrage funds are actively managed funds, their expense ratios are high. The expense ratio charged on direct plans is in the range of 0.2 to 0.5% and 0.8 to 1.1% on regular plans. (Source – AMFI)

These funds have been a popular choice for investors looking for moderate returns with relatively lower risk. The performance of arbitrage funds typically hinges on the volatility in the market. When the volatility is substantial, it can lead to higher returns for the fund.

Pros of Investing in Arbitrage Funds

  1. Lower Risk: These funds aim to minimize risk by taking opposing positions in different markets, making them a safer option for conservative investors.
  2. Tax Efficiency: One of the standout advantages of Arbitrage Funds in India is their favourable tax treatment. They are considered equity-oriented funds for tax purposes. Therefore, your post-tax returns from this fund can be higher than FD or liquid funds.
  3. Liquidity: Arbitrage Funds typically have high liquidity, allowing investors to buy and sell units easily, making them suitable for short-term investments.

Cons of Investing in Arbitrage Funds

  1. Market Dependency: Arbitrage opportunities depend on market inefficiencies, which can be scarce during certain market conditions.
  2. Irregular Returns: Though in the long run, the arbitrage funds have given an average return of 6.5%, their returns aren’t consistent. These funds depend on market inefficiencies. You may need to analyse the market conditions before selecting an arbitrage fund over debt-liquid funds.
  3. Expense Ratio: Like other mutual funds, Arbitrage Funds have an expense ratio that could eat into your returns. It’s crucial to consider this when evaluating the overall performance.

Should You Invest in Arbitrage Funds?

The decision to invest in an Arbitrage Fund depends on your financial goals and risk tolerance. Here are some scenarios where an Arbitrage Fund might make sense:

  1. Short-Term Goals: If you have short-term financial objectives and need to park your money for a brief period, Arbitrage Funds can be a good choice because of their liquidity, low risk and tax benefits. But remember, only invest in this fund if you can hold your investment for a minimum of 6 months.
  2. Tax Efficiency: If you’re looking to minimize tax liability, especially for short-term gains, these funds can help you optimize your tax obligations. Tax-wise, this equity hybrid fund can save more tax for you when compared to FD or debt-liquid funds.
  3. Risk Aversion: If you are averse to market risk and prefer safer, moderate returns over higher but uncertain growth, arbitrage funds can be a reliable option.

On the other hand, if you are seeking substantial growth, will accept higher volatility, or have a longer investment horizon, you might want to explore other investment avenues.

Share these insights with your buddies. Until next time!

Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

ET Money – Arbitrage Funds: How They Work | Who Should Invest?

Mint – Arbitrage funds’ spreads are attractive, and investors must take advantage

DSP – Arbitrage Funds

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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