Arbitrage funds are a kind of mutual funds that try to obtain gains through price differences in different markets. It means that the security is purchased at one market and sold at another at different prices. This mostly takes place between cash and derivative markets. These funds are low-risk because they emphasise price movements over the short term. Investors who need a stable return with low risk may find arbitrage funds useful. This blog explains the features, workings, benefits, and risks of arbitrage funds.
What are Arbitrage Funds?
Arbitrage funds are a type of hybrid mutual fund that tends to generate capital gains by using price differences in the markets. It focuses on buying and selling securities in two different markets at different prices. For instance, if a fund manager buys a stock at a lower price in one market and sells that same stock at a higher price in another market, the difference between the two prices is the gain for the fund manager. This strategy is known as arbitrage.
Arbitrage funds are invested in equities, stocks, and debt instruments, such as bonds or short-term securities. The aim is to earn steady returns. In most cases, the profits will be small due to the narrow price differences.
How Do Arbitrage Funds Work?
Arbitrage funds operate on the concept of taking advantage of market price differences. Such differences may arise in two major ways:
- Between Exchanges: A share can be traded at a different price on different exchanges. In this case, the fund buys at the lower price and sells at the higher price.
- Between the Spot and Futures Markets: A stock can be priced higher in the cash (spot) market than in the futures market. The fund manager can buy the stock in the spot market and sell it in the futures market at a higher price.
The fund manager looks for the price differences and buys and sells stocks simultaneously, gaining profit without taking much risk. This process is repeated as new arbitrage opportunities arise.
Features of Arbitrage Funds
Arbitrage funds have several unique features, such as:
- Equity Orientation: Arbitrage funds invest at least 65% of their investments in equities.
- Low Risk: Arbitrage funds have a relatively lower risk than pure equity funds as they are based on the difference in prices.
- Hedged Exposure: The arbitrage fund hedges its positions, hence reducing possible losses, which appears to be safer compared to equity funds.
- Suitable for Unstable Markets: Arbitrage funds work in unstable markets with lower risk compared to the other forms of investment.
Arbitrage funds may potentially lead to stable returns during volatile markets while providing the safety that traditional equity investment fails to do.
Advantages of Investing in Arbitrage Funds
The key advantages of investing in arbitrage funds are as follows.
- Low-Risk: Arbitrage funds depend on price variance instead of trends in the market. Hence, it is relatively less affected by changes in the market.
- Stable Returns: Arbitrage funds may tend to provide stable returns even if the markets are volatile. The capital gains are generally small but consistent.
- Tax Benefits: Arbitrage funds are considered equity funds, so long-term capital gain is completely tax-free up to Rs. 1 lakh. Above this limit, it will be taxed at 10%. For short-term capital gains, the tax rate is 15%.
Risks of Arbitrage Funds
Several associated with arbitrage funds are as follows.
- Small Profits: The price differences that generate profits are usually small, so the returns may not be as high as other investment options.
- Expense Ratios: Arbitrage funds often have higher management fees because they require active monitoring and frequent transactions.
- Market Volatility: Arbitrage funds can be affected by sudden market changes, which may impact price differences and reduce the expected returns.
Who Should Invest in Arbitrage Funds?
The arbitrage funds may tend to be suitable for the following types of investors.
- Risk-Averse Investor: Arbitrage funds can be useful for risk-averse investors looking for low-risk investment opportunities.
- Short- to Medium-term Investors: If a stable return over a short or medium-term horizon is needed, then arbitrage funds may help.
- Portfolio Balancing: Arbitrage funds help balance a portfolio comprising low-risk investment assets.
If you are considering investing in arbitrage funds, you can explore a mutual fund app for easier access to various schemes.
Taxation of Arbitrage Funds
Arbitrage funds are taxed similarly to equity mutual funds. Tax rules apply to such funds as mentioned below:
- STCG: At 15% if sold within one year
- LTCG: At 10% if held for more than one year and returns exceed Rs. 1 lakh
The taxation structure of arbitrage funds makes it more attractive than many other low-risk investment options.
Conclusion
Arbitrage funds provide a low-risk investment opportunity with steady returns. These funds are designed to generate consistent capital gains by leveraging the price differences of various markets. Although they may carry less risk than traditional equity funds, the returns may be less. While investing in arbitrage funds, one should consider the expense ratios, returns, and taxation. If you want to invest in a low-risk investment that includes both equity and debt, you may potentially consider investing in arbitrage funds. However, always read scheme-related details carefully before investing.
