Arbitrage Funds | Working, Features, Advantages and Disadvantages

What are Arbitrage Funds?

Arbitrage Funds are equity-oriented hybrid funds that take advantage of market arbitrage opportunities. An arbitrage fund’s fund manager buys and sells shares at the same time, earning the difference between the selling and buying prices. This is distinct from any other type of investment in which you buy an asset and wait for its value to increase before selling it. The fund manager of an arbitrage fund invests in shares only when he sees a clear opportunity to gain returns. If no arbitrage possibilities exist, the fund will invest in short-term money market instruments and debt securities. The main thing to remember here is that the price difference is usually insignificant. As a result, the fund manager must execute multiple deals in a single day in order to generate a reasonable profit. Pricing mismatches between two exchanges, differing pricing in the spot and futures markets, and so on are examples.

How do Arbitrage Mutual Funds work?

Arbitrage mutual funds are akin to financial wizards in the investment world. Imagine that you discover two stores that sell the same product, but one offers it at a lower price than the other. You could make a profit by purchasing from the lesser store and selling to the more pricey store. The only difference is that arbitrage mutual funds invest in financial markets as opposed to retailers. They identify disparities in prices between related assets, such as equities and bonds, and profit from these price differences. This process contributes to keeping the prices of these assets in equilibrium. It can provide investors with a comparatively low-risk way to earn a profit, similar to a savvy bargain hunter making a profit by noticing and exploiting market price differences.

Case 1: Price Difference between Exchanges

Let’s assume that the price per share of Johar Limited’s stock on the Bangalore Stock Exchange (BgSE) is 800 and the Patna Stock Exchange (PSE) is ₹900.  If an arbitrage fund manager recognizes this opportunity, he purchases shares from the BgSE and concurrently sells them on the PSE. This enables him to make a risk-free profit of ₹100 per share (less transaction fees).

Case 2: Price Difference between the Cash Market and Future Market

Suppose a share of Johar Limited trades for ₹1,000 on the cash market and ₹1,025 on the futures market. The arbitrage fund’s manager purchases shares from the cash market and constructs a futures contract to sell the shares at ₹1025. He sells the shares on the futures market at the end of the month for a risk-free profit of ₹25 per share (less transaction costs).

Features of Arbitrage Mutual Funds

The goal of arbitrage mutual funds is to produce returns by taking advantage of price discrepancies in the financial markets. These funds earn a very low-risk return by taking advantage of price disparities between the cash and derivative markets, typically stock and equity-related products. Key features of arbitrage mutual funds include the following:

1. Investment Strategy: Arbitrage mutual funds use an arbitrage strategy, which involves buying and selling securities in multiple markets at the same time in order to profit from price differences. They usually invest in both cash (stock) and derivatives (futures and options).

2. Lower Risk: Arbitrage methods are thought to be low-risk since they seek to profit from market inefficiencies rather than change influencing the market. Because they attempt to catch modest pricing discrepancies, the possibility of substantial losses is restricted.

3. Short-Term Investments: Arbitrage funds often have a limited investment horizon, holding holdings for a few days to a few weeks. The idea is to benefit quickly from short-term price disparities.

4. Diversification: To limit individual security risk, these funds often invest in a diverse variety of securities and derivatives.

5. Volatility: Arbitrage funds are typically less volatile than pure equities funds. However, market volatility, higher interest rates, and other factors can still have an impact on their returns.

Who should Invest in Arbitrage Mutual Funds?

An arbitrage fund has the same level of risk as a debt fund. There are many arbitrage funds that base their investments on the liquid fund index. Arbitrage funds are great for people who want to invest in stocks but don’t want to take the risks. When the market is volatile, buyers who don’t want to take risks can put their money in an arbitrage fund and still make good money.

Arbitrage mutual funds may be a good choice for the following types of investors:

1. Investors Who Don’t like Taking Risks: If you don’t like the higher risks that come with pure equity investments but still want to take advantage of stock market chances, arbitrage funds are a safer option.

2. Temporary Investors: Those who only need the money for a short time: These funds are often used to store money that you might need in a few months. They might give you a little more money back than regular savings accounts or fixed deposits.

3. Tax Savers: In certain countries, arbitrage funds can provide rebates on taxes. To give you an example, in India they are taxed as stock funds, which can save you money in the long run.

4. Market Fluctuations Avoiders:  If you’d rather invest in something more stable, arbitrage funds might help you escape unpredictable price fluctuations that happen in regular stock markets.

Factors to consider before Investing in Arbitrage Mutual Funds in India

Here are some important components to consider before investing in arbitrage funds in India:

1. The Fund Manager’s Role: The fund manager seeks out arbitrage possibilities and uses them to meet the scheme’s investment goal. In addition, he commits a small amount of his assets to high-quality fixed-income securities. This helps him to maintain consistent earnings even when arbitrage opportunities are scarce.

2. Risks and Returns: Because the fund manager buys equities in one market and sells them in another, there is no equity exposure risk. These opportunities, however, are limited, and the price difference is negligible. As a result, the returns are average. Returns of roughly 8% might be expected if you stay invested for 5-8 years. However, keep in mind that there is no guarantee of profits with arbitrage funds.

3. Expense Ratio: The expense ratio, expressed as a percentage of the fund’s total assets, is the cost charged by the fund house for fund management services. Every day, trades are executed in an arbitrage fund. As a result, transaction costs can be enormous. Furthermore, many arbitrage schemes charge an exit fee if you redeem your shares within 30 or 60 days of purchase.

Advantages of Arbitrage Funds

1. Lower Risk: Arbitrage funds typically have a low level of risk for the investor. Because each security is bought and sold at the same time, there is essentially no risk associated with longer-term investments.

Arbitrage funds may also invest a portion of their capital in debt instruments, which are generally seen as fairly stable. When there is a scarcity of attractive arbitrage deals, funds increase their debt exposure. This makes this form of investment particularly enticing to investors who have a low risk tolerance.

These funds are among the few low-risk investments that thrive during periods of significant market volatility, which can cause investor worry. When prices are volatile, the difference between the cash and futures markets widens. Individual stock values do not fluctuate significantly in a highly stable market. When markets are tranquil, investors have no reason to anticipate stock values will be much different from current levels in a month’s time.

Volatility and risk are inextricably linked. Volatility is required for large gains or losses. Arbitrage funds are a fantastic option for conservative investors looking to profit from a turbulent market without taking on too much risk.

2. Taxed as Equity Funds: Although arbitrage funds generally invest in equities, they are technically balanced or hybrid funds since they invest in both debt and equity. As a result, they are taxed as equity funds because long equity accounts for at least 65% of the portfolio on average.

3. Low Expense Ratios: Arbitrage funds typically offer lower expense ratios than actively managed equities funds, allowing investors to continue to receive more of their returns.

4. Consistent Returns: Arbitrage funds typically offer consistent, moderate returns. They seek consistency when it comes to performance rather than vigorous capital building, which may appeal to risk-averse investors.

Disadvantages of Arbitrage Funds

1. Uncertainty: One of the main downsides of arbitrage funds is their lack of dependability. As previously stated, arbitrage funds are not highly successful in stable markets. If there aren’t enough profitable arbitrage deals available, the fund may, albeit temporarily, become a bond fund. Extended amount of time spent on bonds can significantly lower the fund’s profitability, therefore actively managed equities funds beat arbitrage funds in the long run.

2. Limited Return Potential: While they are less risky, arbitrage funds often have lower return potential than equities funds. They might not produce high returns during periods of rapid market expansion.

3. Management Expertise: The ability of the fund manager to recognize and exploit price disparities is critical to the success of arbitrage strategies. The fund’s effectiveness is heavily reliant on the management team’s skill and experience.

4. Market Conditions: The presence of arbitrage possibilities in the market is critical to the performance of arbitrage funds. These funds may underperform during periods of extreme market volatility or when arbitrage opportunities are sparse.

In conclusion, arbitrage mutual funds can be a valuable complement to a well-diversified investment portfolio, particularly for risk-averse investors seeking low-risk, consistent returns. However, they may not be appropriate for investors expecting large returns or those with a longer time horizon. Before incorporating arbitrage funds into your investment strategy, you should carefully consider the objectives of your investment and risk tolerance, as well as speak with a financial professional.