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Arbitrage funds take advantage of market movements and price differences in two different markets. Namely, the cash or spot market and futures market. Also, the price differences are very minute. Hence the fund manager has to be efficient in identifying such opportunities in the market. Arbitrage mutual funds in India appeal to those investors who want to benefit from volatile markets without much risk. Arbitrage funds are covered in detail in this article.

arbitrage funds
arbitrage funds

What is an arbitrage fund?

India arbitrage fund is a type of equity-oriented hybrid mutual fund which makes a profit out of the difference in pricing of securities in two different markets. The securities are bought at lower prices from the cash market and sold in the futures market at a higher price. The difference is the profit earned through arbitrage. Hence, arbitrage funds perform well in a volatile market.  

A majority of the time, the difference in pricing in the cash market and futures market is tiny. The arbitrage fund invests in a huge number of opportunities per day to make profits. The tax for equity arbitrage funds is similar to equity mutual funds. The fund house allows investors to do a lump sum investment or a SIP investment in arbitrage funds. Additionally, one can also opt for a systematic transfer plan (STP). The minimum investment amount varies from  INR 1,000-INR 5,000. And, the minimum  SIP investment amount is INR 500.

How does an arbitrage fund work?

The India arbitrage fund makes a profit out of the pricing difference in 2 different markets of the same security. The two markets are Stock Market and Futures Market. In other words, arbitrage funds generate returns from the price difference of the share in both the markets. If the market is expected to go up, a certain number of shares are bought in the stock market and simultaneously sold on the futures market. On the contrary, if the market is expected to fall, the arbitrage fund will short sell in the stock market and purchase the share at a lesser price in the futures market.

Cash or Stock Market

The cash market is commonly known as the stock or spot market. Hence, the price of a security in the stock market is called the spot price.

Futures Market

The futures market is an equity derivatives market, and it features only the expected future price of the securities. To trade on security for an expected future price, an investor will have to enter into a futures contract for a future date. The future date is known as the maturity date.

The transfer of securities takes place to the investor at the maturity date of the contract. On the maturity date, the transaction takes place at a price agreed while entering into the contract.

Buying and selling of securities

For instance, the arbitrage fund purchases 10,000 shares of ABC Company for INR 50 per share at the beginning of June. Simultaneously, it sells 10,000 shares of the July Futures contract of ABC Company for INR 65. Here two possibilities can happen at the end of July.

Scenario 1: If the share price of ABC Company increases

Stock Price at expiry (end of July): INR 70

Profit/Loss in the stock market (Spot transaction): (70-50)*10,000 = INR 2,00,000

Profit/Loss in the derivatives market (Futures transaction): (65-70)*10,000 = (-) INR 50,000

Net Profit = 2,00,000 – 50,000 = INR 1,50,000

Scenario 2: If the share price of ABC Company decreases

Stock Price at expiry (end of July): INR 40

Profit/Loss in the stock market (Spot transaction): (40-50)*10,000 = (-) INR 1,00,000

Profit/Loss in the derivatives market (Futures transaction): (65-40)*10,000 = INR 2,50,000

Net Profit = – 1,00,000 + 2,50,000 = INR 1,50,000 

For the above example, both the scenarios are profitable irrespective of the market direction. However, in reality, the price difference is very less between the stock market and futures market. To achieve good returns, the fund needs to transact in higher amounts in a single day.

Role of Arbitrage Fund Manager

Arbitrage mutual funds  in India take advantage of the markets to generate profits. The fund invests in both equity and debt securities. The profits are realized over a medium time horizon. The medium term investment horizon handles the volatility risk. The volatility risk usually arises due to equity exposure. The portfolio manager identifies the arbitrage opportunity and takes a position to align with the funds objective. 

Additionally, some portion of the asset is invested in fixed income instruments. The fund manager ensures that these instruments are of high credit quality only. Some of these high credit quality debt instruments are zero-coupon bonds, term deposits, and debentures. During inadequate arbitrage opportunities, this strategy of investing in fixed income helps keep up with the fund returns.

Therefore, the arbitrage fund manager’s role is to identify an opportunity in the spot and futures market. Also, the fund manager of the fund house ensures that the assets are invested in fixed income securities to generate returns during low arbitrage opportunities.

Who should invest in these funds?

Arbitrage mutual funds in India generate profits from low-risk buy and sell opportunities in the spot and futures market. Arbitrage funds can have similar risk levels as debt funds. Therefore, investors seeking low risk like debt funds, but with a little equity exposure can invest in arbitrage funds.  Mostly, Crisil BSE 0.23% Liquid fund is the benchmark fund for several arbitrage funds. Arbitrage funds are the best funds to invest in volatile markets.

Arbitrage funds are best suited for investors looking for equity exposure but are not high-risk takers. The risk profile of these funds is similar to that of a debt fund. For short to medium financial goals, arbitrage funds are the right funds to invest. They are safe options in times where the market is fluctuating. Therefore, these funds benefit from fluctuations. Arbitrage funds are for investors seeking good returns from a volatile market while taking a calculated risk.

Investors can do a lump sum investment or a SIP investment in arbitrage funds. Additionally, one can also opt for a systematic transfer plan (STP). Investors can determine potential sip returns from arbitrage funds using Scripbox’s SIP Calculator

Purchase of arbitrage funds can be done through a fund house directly, or any intermediary or from the stock exchange using a Demat account

Benefits of investing in Arbitrage Funds

 Risk

The major advantage of investing in arbitrage opportunities fund is the risk involved in it. These funds have very low risk. This is because the funds buy and sell securities almost immediately that there is no risk of long term investment. A part of the assets is invested in debt securities, making it a stable investment option. When the portfolio manager finds no investment opportunities in the market, the asset allocation is majorly towards debt securities, making it ideal for low-risk investments. Hence, investors can align their financial goals with that of the fund’s objective. And find the right arbitrage funds to invest in.

Volatility

Volatile markets are not ideal for many investors. But when it comes to arbitrage funds, volatility is a boon. When the market is volatile, the price difference between the spot and futures market can be uncertain. People would be unsure about their actions, whether to buy or sell, making the market more volatile. In a calm market, no one would believe that the price difference would be much. Hence no volatility in the market. Volatility in the market can drive the market up and down. Thus, leading it to cause huge gains or losses. By identifying the right opportunity, investors can take advantage of the situation. Arbitrage fund managers do just this to earn significant returns. Arbitrage opportunities fund is the best fund to invest in volatile markets .

Taxed as equity funds

Arbitrage fund is a hybrid fund . However, this hybrid fund is taxed exactly like equity mutual funds . This is because the asset allocation is such that at least 65% of the assets are invested in long equity. Hence, the taxation is similar to equity funds, which is 15% for short term capital gains and 10% for long term capital gains (above INR 1 lakh). This tax rate is much lower than the income tax slab rate for investors who fall under INR 2,50,000 and above.

Disadvantages of Arbitrage Funds

High expense ratio

Arbitrage funds work when multiple transactions are performed. This is because the price difference in different markets will not be high. To benefit from it, numerous transactions have to be done. This, in turn, increases the expense ratio and decreases the net asset value (NAV) of the fund. Investors should keep a check on the expense ratio of the fund as they eat into the profits (net asset value) of the fund.

Unpredictable payoff

Arbitrage funds perform well in a volatile market, provided the fund manager has taken advantage of the right opportunities. These funds cannot be relied upon as in stable markets. In stable market conditions,  funds majorly invest in bonds. Hence splitting the asset allocation between two asset classes. This reduces the return of the fund when compared to actively managed equity funds. Hence, their unpredictability and low reliability can affect investor confidence.

Points to consider before investing in these funds

Higher Investments Required

The profit is the difference in pricing in two different markets, and this difference is tiny. Since the difference is minimal, an investor will have to invest a higher amount to make an average profit. The quantum of trades in these funds must be high.

Example;

Price of stock in the stock market- Rs 1215

Price of stock in the futures market- Rs 1215.15

Here the difference is the price is just Rs 0.15.

Hence to make a high an=mount of profit, a high amount of capital must be invested.

Risk of profit and investment

The risk of profit and capital is not high as the profit is based on price in two markets, which is already known to the fund manager at the time of investing in the long term.

When a transaction is made in the stock market only, the risk of market movements to equity is exposed to the investment. But when the transaction is made in stock in the stock market and futures market, the risk seems to cut down. 

The volatility of the market

The fund managers can benefit from market volatility and make remarkable profits. The higher the movements in prices in both markets, the higher will be the difference in prices leading to higher profits.

The benefit of volatility is available to all the investors who will make a transaction. As more and more investors make more and more transactions, the difference between both markets will scrape away. Hence, there will be very little chance of profits.

Cost on Investment

The cost of investments in arbitrage funds is higher in comparison to other funds. An annual fee is charged on the funds’ overall asset known as the expense ratio. These costs include the fund manager’s fee, fund management fee.

Since the arbitrage fund involves multiple transactions, the total transaction cost on the fund is high. Post all these expenses, and if an investor wants to exit early, the exit load fee is also levied.

Hence, it is advisable to calculate the expenses of managing and maintaining the fund wisely before investing in arbitrage funds.

Tax on arbitrage mutual funds

Arbitrage funds are equity mutual funds. Hence the tax treatment is similar to the tax on equity funds. The tax on equity arbitrage funds is:

Investment PeriodAmount of gainNature of taxRate of tax
Less than 12 monthsAny amountSTCG15%
More than 12 monthsLess than 1 lakhLTCGExempt
More than 12 monthsMore than 1 lakhLTCG10% of gains over 1 lakh

To understand more about Mutual Fund basics refer to the article How Mutual Funds Work?

Frequently Asked Questions

Are arbitrage funds tax efficient?

No, arbitrage funds are not tax efficient. To save tax, one can invest in Equity Linked Savings Scheme (ELSS) mutual funds or other instruments that qualify for Section 80C deductions. For tax savings with equity exposure, investors can choose ELSS funds. However, mutual funds investment is subject to market risks. Hence investors should proceed with funds that best suit their financial goals. 

What are the types of hybrid mutual funds?

A Hybrid mutual fund invests both in equity and debt. They best suit investors with a medium-term horizon. However, for a short term horizon, debt mutual funds and bond funds are a better option than fixed deposit or saving account. Also, for the long term, equity mutual funds are the best choice.
The types of Hybrid Funds are: 
1.Aggressive Hybrid Funds
2.Dynamic Asset Allocation or Balanced Advantage Funds
3.Equity Savings Fund
4.Conservative Hybrid Fund
5.Arbitrage Funds
6.Multi-Asset Allocation Fund
7.Balanced Hybrid Fund

Published on January 17, 2020