Arbitrage Funds: A Smart Investment Move For Europeans

Arbitrage funds are a type of mutual fund that aims to profit from price differentials in different markets. They do this by buying and selling securities simultaneously in two or more markets, exploiting tiny differences in the asset's listed price. This strategy is particularly effective in volatile markets and can offer investors a way to profit from market volatility with relatively low risk. Arbitrage funds are also taxed similarly to equity funds, making them a tax-efficient investment option. These funds are suitable for investors with a low-risk appetite and are a good choice for those looking to maintain liquidity. However, it is important to note that arbitrage funds may not perform well when markets are stable and calm, and they can have high expense ratios. Overall, arbitrage funds provide a unique opportunity for investors in Europe and elsewhere to profit from market inefficiencies while minimising risk.

Arbitrage funds are a good choice for investors who want to profit from a volatile market without taking on too much risk

One of the key advantages of arbitrage funds is their low-risk nature. Since the funds buy and sell securities simultaneously, there is virtually none of the risk associated with long-term investments. This makes them particularly suitable for investors with a low-risk appetite. Additionally, arbitrage funds can also invest a portion of their capital in debt instruments, which are generally considered stable and further reduce the risk for investors.

Another benefit of arbitrage funds is their performance during volatile market conditions. Volatility provides more opportunities for price differentials between markets, allowing arbitrage funds to generate higher returns. This is in contrast to stable markets, where arbitrage opportunities are limited. Therefore, arbitrage funds are well-suited for investors who want to profit from volatile markets.

It is important to note that arbitrage funds have some drawbacks. One of the main disadvantages is the unpredictable payoff. Arbitrage funds may not perform well during stable market conditions, and their returns can be unpredictable. Additionally, arbitrage funds can have high expense ratios due to the large number of trades they execute.

In summary, arbitrage funds offer a good opportunity for investors who want to profit from volatile markets while minimising risk. They provide a low-risk investment strategy by taking advantage of price differentials in different markets. However, investors should also be aware of the potential drawbacks, such as unpredictable payoffs and high expense ratios, before deciding to invest in arbitrage funds.

Arbitrage funds are taxed like equity funds

Arbitrage funds are a type of mutual fund that aims to profit from the price differential of identical or similar assets in different markets. They are taxed like equity funds because, despite investing primarily in equities, they are technically balanced or hybrid funds, investing in both debt and equity.

In India, for example, the Income Tax Act states that if the average of the opening and closing of the arbitrage equity exposure over a 12-month period is over 65%, the fund is taxed as an equity fund. Similarly, in the US, if long equity represents an average of at least 65% of the portfolio, the fund is taxed as an equity fund.

The benefit of this is that, if you hold your shares in an arbitrage fund for more than a year, any gains you receive are taxed at the capital gains rate, which is much lower than the ordinary income tax rate.

In April 2023, the benefits of long-term capital gains from debt-based investments (with less than 35% equity allocation) were eliminated in India. As a result, debt mutual funds are now taxed according to the income tax slab rate. This makes arbitrage funds even more attractive for investors, as they offer a more favourable tax treatment.

Arbitrage funds are suitable for new investors and investors with a low-risk appetite

Arbitrage funds are considered low-risk because they involve the simultaneous buying and selling of securities, eliminating the risks associated with long-term investments. They are also suitable for low-risk investors as they invest part of their capital in debt securities, which are typically stable. During times of high market volatility, when uncertainty among investors is common, arbitrage funds can be one of the few low-risk securities that flourish.

Additionally, arbitrage funds are taxed like equity funds, which can result in lower taxes on gains. For example, if arbitrage funds are held for more than a year, gains are taxed at the capital gains rate, which is often lower than the ordinary income tax rate.

However, it is important to note that arbitrage funds may not be very profitable during stable markets, and their payoff can be unpredictable. They also require a large number of trades to make substantial gains, resulting in high expense ratios. Therefore, despite their low-risk nature, arbitrage funds should not be the only type of investment in an investor's portfolio.

Arbitrage funds are equity-oriented hybrid funds

The fund manager of an arbitrage fund buys and sells shares at the same time, earning the difference between the selling price and the buying price. This is fundamentally different from other forms of investing, where an investor purchases an asset and waits for it to grow in value before selling it.

In an arbitrage fund, the fund manager only invests in equities when they find a definite opportunity to earn returns. If there are no arbitrage opportunities available, the fund invests in short-term money market instruments and debt securities. It is important to note that the price difference is usually very small, so the fund manager has to make several trades in one day to book a reasonable profit.

Equities and equity-related products must account for at least 65% of an arbitrage fund's portfolio. These funds also provide hedged exposure and have the potential to outperform non-equity-oriented funds in terms of post-tax returns. They are suitable for unstable markets and are the only low-risk investment that thrives in a volatile market.

Arbitrage funds are suitable for investors with an investment horizon of 6 months to 2 years

One of the key advantages of arbitrage funds is their low-risk nature. As they buy and sell securities at the same time, they eliminate the risks associated with long-term investments. This makes them particularly attractive to investors with a low tolerance for risk. Additionally, arbitrage funds can provide stable returns during times of high market volatility, which can be reassuring for cautious investors.

When considering arbitrage funds, it is important to keep in mind the potential for unpredictable payoffs and high expense ratios. The payoff can be unpredictable, especially during stable markets when there may not be enough profitable arbitrage trades available. Arbitrage funds also tend to have high expense ratios due to the large number of trades they execute each year to generate substantial gains.

For European investors, arbitrage funds offer an opportunity to diversify their portfolios and benefit from market volatility. These funds are well-suited for those seeking low-risk investments with the potential for decent returns over a 6-month to 2-year period. However, it is always recommended to consult with a financial professional before making any investment decisions to ensure that arbitrage funds align with your specific investment goals and risk tolerance.

Frequently asked questions