Arbitrage Mutual Funds: Low-Risk, Tax-Efficient Returns Explained

What is an Arbitrage Mutual Fund?

An Arbitrage Mutual Fund is a type of mutual fund that is designed to earn profits by exploiting pricing differences between the cash market (spot market) and the derivatives market ( futures market). Such funds seek temporary prices discrepancies between these markets to obtain risk-free profits. This is a common approach in some of the top arbitrage funds today.

This type of fund comes under the equity-oriented category of mutual funds because it primarily invests in equity instruments and related ones. The stock, debt, and money market-based products can be brought in under the equity arbitrage fund schemes. They must purchase and sell an equal amount of an asset in two distinct markets simultaneously to take advantage of any price disparity.

According to the mandates of the Securities and Exchange Board of India, Arbitrage funds must have at least 65 per cent of their total funds in equities. They also taxed as equity funds and tend to follow an index such as the Nifty 50 arbitrage index.

How Arbitrage Mutual Funds Work??

Arbitrage funds buy low in one market and sell at a premium in another, and their objective is to gain profit that has no risk or little risk as a result of the difference in prices. Such funds normally trade in both cash and derivative markets (futures etc) to exploit any available arbitrage opportunities.

Step-by-Step How They Work

Spot Futures Price Difference

Consider that the stock of XYZ has a current price of Rs.2500 in the cash market and Rs.2520 in the futures market for the same expiration date.

Sell and Buy Simultaneously

• The fund manager buys XYZ shares in the cash market for Rs.2,500 .
  and sells (or buys futures) at Rs.2520 simultaneously.

Wait until Expiry

• At the futures contract expiration, the futures price aligns with the cash market price.

Both of the positions are closed

Both the positions are closed, resulting in a profit of 20/- per share (less costs). This is a classic example which demonstrates the arbitrage strategy.

Debt Investments

When none of the desirable arbitrage opportunities exist, the fund takes up any remaining cash in low-risk debts, such as liquid funds or short-term bonds. These allocations may influence arbitrage fund returns.

Major Features of Arbitrage mutual funds

The purpose of arbitrage mutual funds is to generate returns using the price differences within the financial markets. Such funds achieve very low risk but high-income yield by exploiting price differences between the cash and derivative markets, involving stock and equity-based products. Salient characteristics of arbitrage mutual funds are as follows:

1. Investment Strategy: Arbitrage mutual funds have an investment strategy where the fund buys and sells securities simultaneously on two or more markets to take advantage of the price difference. They tend to invest in cash in stock as well as in derivatives, namely, futures and options. Some schemes also track the arbitrage stocks list for better opportunities.
2. Less Risk: Arbitrage techniques are believed to be at low risk because it does not aim at altering the market but exploiting it based on market irrationality. The risk of incurring high losses is limited since they target to capture small margins in the price.
3. Short-Term Investments: The investing period of arbitrage funds is short-lived and generally lasts a few days to a few weeks at most. You can take advantage of the momentary price difference within a short time.
4. Diversification: These types of funds usually invest in a wide range of derivatives and securities to reduce the risks of individual securities.
5. Volatility: Pure equity funds are more volatile as compared to arbitrage funds. But certain factors can affect their returns because of the market volatility and the increase in interest rates.

Advantages of Arbitrage Mutual Funds

The benefits provided by Arbitrage mutual funds are given below:

• Decreased riskiness: Arbitrage funds have lower risks in comparison with traditional equity funds as they aim at exploring the price differences on securities. Since these funds exploit the short-term price inefficiencies, they are not sensitive to overall market fluctuations.
• Chance of stable income: Arbitrage funds can generate steady returns with the help of price fluctuations, even in times of volatility in the market. This is an attractive investment to investors who are seeking stability in their investments. Thorough research on arbitrage funds can help identify the most effective schemes.
• Tax advantages: As with the equity funds, arbitrage funds have certain tax advantages as well. Long-term capital gains that exceed Rs. 1 lakh incur a 10% tax rate whereas short-term capital gains have a 15% tax rate. However, investors should also be aware of the arbitrage fund’s exit load, if any. (Not sure, pls check)

Risks Associated with Arbitrage Mutual Funds

• Low Returns: They usually have low returns which may not even match inflation in the long run.
• Market Dependency: The profits are dependent on the price discrepancies between cash and futures markets that may not be constant.
• Low Opportunity in Stable Markets: Arbitrage opportunities are low when the markets are steady or stable in one direction.
• Liquidity Risk: In volatile market conditions, getting out of positions may not be easy at all.
• Lag in Returns: Arbitrage trades take time to complete and thus you may not get immediate returns.
• Tax on Short-Term Gains: Gains realised within less than a year are taxed at a 15% rate. (not sure, pls check)

Who Can Benefit from Investing in Arbitrage Funds?

The person who can receive good returns by investing in Arbitrage mutual funds are given below:

• Conservative Investors: It is ideal for people who seek little exposure to equity markets and prefer low-risk returns.
• Short-term Investors: It is excellent for investors whose financial objectives are in the short term and seek higher returns compared to savings accounts or liquid funds.
• High-Tax Bracket People: Offers equity-like tax benefits, 15% on short-term and 10% on long-term gains (above 1 lakh), which makes it more tax-efficient as compared to fixed deposits. (not sure, pls check)
• Investors with Surplus Money: A good option to keep aside some money such as bonus money, proceeds of the sale of a house or any additional savings.
• Investors Under Market Volatility: Performs very well in volatile or sideways markets due to better arbitrage opportunities between cash and futures markets.
• Individuals who do not want to take on Equity Risk: It helps anyone who wishes to have some indirect exposure to stocks without having to directly handle all the ups and downs of the market.

Who Should Avoid Investing in Arbitrage Mutual Funds

Investors seeking high or aggressive returns will not find arbitrage mutual funds to be the most suitable because their returns tend to be modest, and they perform like liquid or ultra-short money funds. Instead, long-term investors interested in wealth-building should hold on to equity mutual funds. Also, retail investors who do not understand derivatives, or who prefer an easier approach to investing may find arbitrage systems complex. Markets that are stable or trending may not provide as many arbitrage opportunities and thus limit the potential returns. Some investors requiring their money back within the very short run (less than 3 months) may prefer liquid funds due to the superior liquidity and reduction of exit load problems.

Important Points to Know before You Invest in Arbitrage Funds

Important Things to know about Arbitrage fund before investment:

• Risk: No price/counterparty risk but it can be a source of credit risk due to debt and may underperform in bearish markets.
• Returns: Good returns in the short term but not guaranteed.
• Horizon: Suitable 3-6 months.
• Amount: Lump-sum preferred over SIP.
• Offer Document: In the offer document, carefully read the fund’s strategy, risk factors, fees, and objectives.
• Asset Allocation: Check equity and debt composition to ensure alignment with your goals.
• Management Fees: This fee is imposed on returns which influences overall profits.

How to invest in arbitrage funds?

To invest in arbitrage funds, follow these steps:

1. Select a fund: See various funds of different Asset Management Companies. Analyse the investment policy of the fund and the experience of a fund manager. Review historical returns data, as far as possible, and remember that historical performance may or may not be repeated in the future..
2. Choose an investment: Invest through a registered mutual fund distributor orthird-party aggregator platforms like Religare Broking
3. Invest in the fund: Ensure you have completed the mandatory KYC process before investing. Choose between a lump sum investment or a Systematic Investment Plan (SIP). Select a payment method and initiate the transaction.