Arbitrage Funds: Strategic Investment Opportunities For Savvy Investors

Arbitrage funds are a type of mutual fund that aims to profit by buying and selling securities across different markets. They are considered low-risk investments because they take advantage of price differentials in these markets, allowing investors to make risk-free profits. For example, an arbitrage fund might buy shares in the cash market and sell them in the futures market, exploiting the difference between the spot price and the futures price. These funds are suitable for investors who want to profit from volatile markets without taking on too much risk. However, the payoff can be unpredictable, and these funds should not be the only type of investment in a portfolio.

Arbitrage funds and volatility

Arbitrage funds are a type of mutual fund that can be a good choice for investors who want to profit from a volatile market without taking on too much risk. They aim to buy and sell securities in different markets, allowing investors to profit from any slight price differentials.

For example, an arbitrage fund may purchase stock in the cash market and simultaneously sell a contract for it on the futures market if the market is bullish. Conversely, if the market is bearish, the fund will purchase lower-priced futures contracts and sell shares on the cash market for a higher current price. This strategy is called index arbitrage.

Arbitrage funds also tend to invest part of their capital into debt securities, which are considered highly stable. This makes them appealing to investors with a low tolerance for risk. They are some of the only low-risk securities that flourish during times of high market volatility.

However, arbitrage funds are not very profitable during stable markets, and their payoff can be unpredictable. They also require a large number of trades to make substantial gains, which means their expense ratios can be high. Therefore, despite their benefits, arbitrage funds should not be the only type of investment in a portfolio.

Arbitrage funds and risk

Arbitrage funds are considered a low-risk investment option. They are a type of hybrid mutual fund that aims to generate returns by buying and selling securities in different markets (cash and futures) simultaneously. This allows investors to profit from any price differentials in these markets.

However, despite their relatively low-risk nature, there are still some risks associated with arbitrage funds. Firstly, the payoff can be unpredictable. Arbitrage funds are not very profitable during stable markets, and if there are not enough profitable arbitrage trades available, the fund may perform more like a bond fund, which can reduce profitability.

Secondly, arbitrage funds can have high expense ratios due to the large number of trades they execute each year and the active management required to identify and capitalise on arbitrage opportunities.

Thirdly, the profit margins from arbitrage tend to be small, limiting the overall return potential compared to other equity-oriented options.

Finally, since arbitrage funds may invest a portion of their corpus in debt instruments, they are susceptible to interest rate risk. Rising interest rates can lead to a decline in the net asset value (NAV) of the fund.

Therefore, while arbitrage funds are considered low-risk, it is important to be aware of these potential risks before investing.

Arbitrage funds and tax

Arbitrage funds are taxed like equity funds. They are taxed similarly to equity funds because they are treated as such for taxation purposes.

If you hold your shares in an arbitrage fund for 12 months or less, any profits are considered short-term capital gains and are taxed at 15%. If you hold your shares for longer than 12 months, any gains are considered long-term capital gains and are taxed at 10% without indexation benefits. However, profits of up to Rs. 1 lakh are tax-exempt in a single financial year.

For investors with higher incomes, arbitrage funds can generate better post-tax returns than non-equity-oriented funds, especially when used to park money. This is because long-term capital gains obtained from other funds are taxed at 20% with indexation if domestic equity exposure is between 35% and 65%.

In April 2023, the government decided that capital gains from debt funds and certain other categories of non-equity mutual funds would be taxed at a higher rate. From this date, gains from mutual funds with less than 35% of their assets in equities are considered short-term capital gains and taxed at the income tax slab rate of the investor, regardless of the holding period. This change has benefited arbitrage funds.

Arbitrage funds and expense ratios

Arbitrage funds are a type of mutual fund that aims to profit by buying and selling securities across different markets. They take advantage of price differentials in these markets, such as the spot-cash market and the futures market, to generate returns. While arbitrage funds are considered low-risk, they also come with unpredictable payoffs and high expense ratios.

Expense ratios are annual fees charged by arbitrage funds, typically as a percentage of the fund's overall assets. These fees cover the fund manager's fees, fund management charges, and transaction costs associated with frequent trading. High turnover ratios and substantial transaction costs can lead to increased expense ratios for arbitrage funds.

When evaluating arbitrage funds, investors should consider the following key points related to expense ratios:

• Cost consideration: Expense ratios impact the returns on your investment. Arbitrage funds with high expense ratios can reduce your take-home returns. Therefore, it is essential to compare expense ratios before selecting a specific fund.
• Frequent trading: Arbitrage funds execute a large number of trades to capitalise on price differentials. This frequent trading results in substantial transaction costs, contributing to higher expense ratios.
• Fund size and experience: Opting for an arbitrage fund with a larger corpus size and an experienced fund manager may help minimise expense ratios. A larger fund size can help distribute costs across a wider investor base, potentially lowering the expense ratio.
• Investment horizon: Arbitrage funds are suitable for short- to medium-term investment horizons, typically ranging from 3 to 5 years. However, they also charge exit loads, so investors should be prepared to stay invested for at least 3 to 6 months to avoid early exit penalties.
• Market volatility: Arbitrage funds thrive during periods of high market volatility, as the differential between the cash and futures markets increases. Therefore, investors should consider market conditions and volatility levels before investing in arbitrage funds.
• Taxation: Arbitrage funds are taxed as equity funds. Long-term capital gains (held for more than a year) above a certain threshold are taxed at a lower rate than short-term capital gains. Understanding the tax implications can help you make informed decisions about when to invest and for how long.

In summary, while arbitrage funds offer the potential for low-risk profits during volatile market conditions, it is crucial to carefully consider the expense ratios and associated costs. By evaluating the fund size, manager experience, investment horizon, market volatility, and taxation, you can make more informed decisions about investing in arbitrage funds.

Arbitrage funds and time horizon

Arbitrage funds are a good option for investors with a short- to medium-term investment horizon. These funds are suitable for those who want to profit from volatile markets without taking on excessive risk. They are also ideal for investors who are looking for equity exposure but are concerned about the associated risks.

Arbitrage funds work by exploiting price differences between securities in the cash and futures markets or between two stock exchanges. They take advantage of changing prices to make calculated and simultaneous buy-and-sell moves, resulting in risk-free profits. The fund manager buys shares in the cash market and sells them in the futures or derivatives markets, profiting from the difference in the cost price and the selling price.

When deciding whether to invest in arbitrage funds, it is important to consider the time horizon. These funds are suitable for investors with a short- to medium-term horizon, typically ranging from 3 years to 5 years. Arbitrage funds charge exit loads, so investors should be prepared to stay invested for at least 3-6 months to avoid these additional costs.

The performance of arbitrage funds is highly dependent on market volatility. Therefore, investors should monitor the overall market scenario and choose lump-sum investments over systematic investment plans (SIPs). Arbitrage funds thrive during periods of high volatility, as there are more arbitrage opportunities available. However, in stable markets with low volatility, the profitability of these funds decreases.

In summary, arbitrage funds are suitable for investors with a short- to medium-term investment horizon who are seeking to profit from market volatility while maintaining a relatively low-risk profile.

Frequently asked questions