What is an Arbitrage Funds?

In investing, you can choose from various types of funds. Riskier, safer, and low-risk funds are designed to generate steady returns with minimal risk. An arbitrage fund is one such type of fund. But what is an arbitrage fund, and how does it work? In this blog, we will look into the concept of arbitrage funds so you can understand what they are, arbitrage fund taxation​, how they work, and whether they might be the right choice.

What is Arbitrage Funds?

Before discussing arbitrage funds, let’s first understand the term. Arbitrage is a financial strategy in which one exploits a difference in prices between two or more markets. It involves acquiring something cheaper from one place and selling it at a higher price in another, resulting in earnings.

For instance, suppose that in one city, a product costs ₹ 100, and in another town, it costs ₹120. An arbitrageur would buy the commodity at ₹100 and sell at ₹120, thus pocketing a ₹ 20 difference. Arbitrage does the same in the financial world, where investors seek to take advantage of slight differences in the price of related markets- between cash and futures- for risk-free profits.

Arbitrage funds use strategies to capture small price movements between these markets and thus register low-risk returns.

Now, let’s break that down a little:

• Cash Market: This is the ordinary stock market where people buy and sell stocks.
• Future Market: This is where contracts (such as futures and options) based on the value of the underlying stock or asset are traded.

Arbitrage funds generally invest in stocks in the cash market and simultaneously sell or buy related contracts in the derivatives market if there is a price difference (or vice versa). The aim is to reap the difference without increasing significant risks.

How do Arbitrage Funds Operate?

Arbitrage funds operate in these ways:

1. Identifying Price Discrepancies

Arbitrage funds look for opportunities where the price of an asset, like a stock, differs between two related markets. These opportunities are often found between:

• Cash Market (Spot Market): You buy and sell stocks or securities for immediate delivery.
• Futures Market: You agree to buy or sell a stock at a specific price on a future date.

2. The Arbitrage Process

When a price discrepancy is identified, the arbitrage fund takes the following steps:

• Buy the asset in the cheaper market (e.g., the cash market).
• Sell the same asset in the more expensive market (e.g., the futures market).

This simultaneous buying and selling allows the fund to lock in a profit, which is the difference between the price in the two markets. The price difference could be due to supply and demand, market inefficiencies, or investor sentiment.

3. Low Risk, Low Return

Arbitrage mutual funds are considered low-risk because they involve buying and selling the same asset simultaneously, minimising exposure to market movements. The risk is shallow since they are not betting on whether a stock will go up or down. However, the profits from these trades are typically small, so the arbitrage fund returns are also modest.

Key Features of Arbitrage Funds

The key features of arbitrage funds are below:

• Low Risk: Arbitrage funds are generally considered low-risk based on market price differences. The profit comes from the convergence of prices in the cash and derivatives markets, not from guessing whether stock prices will go up or down.
• Returns are Normally Moderate: Arbitrage trading returns are typically modest but stable. Such funds seek relatively low and steady returns, usually 5-8 per cent annually. Therefore, they’re less thrilling than other investments but are more stable and predictable.
• Market Neutral: These arbitrage funds are market-neutral, meaning they don’t care about the direction of a stock market. Whether going up or down, the idea is to extract price differences.
• Taxation: The arbitrage fund taxation suffer variations in their taxation treatments following the holding period. If held for less than three years, they are taxed as STCG; if held for more than three years, they are taxed as LTCG, which might have a lower tax rate.

Risks of Arbitrage Funds

Arbitrage incurs a few risks that you should know about to stay informed:

1. Market Risk: Unexpected price fluctuations in the cash or futures market can reduce profits or cause losses.
2. Liquidity Risk: Difficulty buying or selling assets due to low trading volumes can affect the execution of arbitrage trades.
3. Execution Risk: Delays in executing trades can lead to missed profit opportunities as price differences may vanish.
4. Interest Rate Risk: Rising interest rates can increase borrowing costs, reducing profitability for leveraged arbitrage strategies.
5. Transaction Costs: High transaction fees (brokerage, taxes) can eat into small arbitrage profits, making the strategy less effective.

Benefits of Investing in Arbitrage Funds

The benefits of Arbitrage funds are given below:

• Low Volatility: Since arbitrage funds are market-neutral, they tend to be less volatile than other equity funds. Thus, they would be a perfect investment avenue for conservative investors who want to avoid sharp portfolio movements.
• Suitable for Risk-Averse Investors: Arbitrage funds might be apt if you don’t want to expose yourself to the risks directly associated with investing in stocks but still want to earn returns from the market. They offer relatively stable returns with a slightly lower level of risk than equity funds.
• Arbitrage funds can Yield: It offers better returns than fixed-income investments. In some cases, they are better than bonds or savings accounts. The arbitrage fund returns​ are usually higher because the fund takes advantage of market inefficiencies.
• Diversification: Arbitrage funds help diversify an investment portfolio. Though they don’t provide the same growth potential as equity funds, they offer a different source of return that is less correlated with the broader stock market.

Disadvantages of Arbitrage Funds

The disadvantages of Arbitrage funds are below:

• Modest Returns: The returns on arbitrage funds are usually low compared with high-risk equity funds or aggressive growth stocks. If you want high growth, you may need more than these funds.
• Limited Market Opportunities: Arbitrage opportunities depend entirely on the differences in pricing between the cash and derivatives markets. Under certain market conditions, these opportunities can be restricted, resulting in fewer profits for the fund than would have been experienced in a more volatile market.
• Tax Considerations: The tax treatment of arbitrage funds needs to be more explicit, although this is particularly pertinent to someone not considering capital gains taxes. Short-term capital gains are taxed higher, so holding the fund longer may be more tax-efficient.
• Requires Expertise: Arbitrage trading requires substantial expertise and resources. The fund manager must be skilled at identifying and completing trades quickly to take advantage of such price differences. Mismanagement or miscalculations can then impact the fund’s performance.

Who Should Invest in Arbitrage Funds?

Arbitrage funds are best for:

• Conservative Investors: Arbitrage funds might be suitable if you are risk-averse and need safer, more predictable returns.
• Short-Term Investors: These funds are also suitable for investors who want to park their money for a shorter tenure. They need the long-term capital appreciation of an equity fund but can provide more stable returns.
• Diversification Seekers: If you invest in equities and want to add a low-risk component to your portfolio, arbitrage funds can help balance your mix.

Difference between Arbitrage and Liquid Funds

The difference between Arbitrage and liquid funds is below:

Aspect	Arbitrage Funds	Liquid Funds
Definition	Arbitrage funds are mutual funds that profit from price discrepancies between related markets, primarily cash and futures. They buy in the lower-priced market and sell in the higher-priced one, aiming to capitalise on small, frequent price differences.	Liquid funds invest primarily in short-term, low-risk debt instruments such as Treasury bills, commercial papers, and certificates of deposit. They aim to provide a safe investment option for short-term goals, with maturities typically up to 91 days.
Risk	Considered low to moderate risk, arbitrage funds face market risk (sudden price fluctuations) and execution risk (delays in trade execution). While risks exist, they are generally lower than those associated with equity funds.	Liquid funds are characterised by shallow risk. They invest in high-quality, short-term debt instruments. The main risks include credit risk (issuer default) and interest rate risk (decline in value due to rising rates). Still, these are minimal given the investments’ short maturities, making them one of the safest options in the mutual fund space.
Returns	Due to their arbitrage strategy, they offer moderate returns, generally higher than those of liquid funds. Returns depend on the frequency and size of arbitrage opportunities and market conditions but are usually lower than equity funds.	Offer low but stable returns, generally lower than equity or arbitrage funds. The conservative nature of their investments results in predictable returns that are higher than savings accounts or fixed deposits but lower than more aggressive investment options.
Investment Horizon	Ideal for medium-term investments, typically ranging from 6 months to 1 year. They are suited for investors looking for low-risk investments with moderate returns over several months, as market inefficiencies take time to materialise.	It is best suited for short-term investments, ranging from a few days to months. It caters to investors needing quick access to funds without capital loss, making it ideal for short-term financial goals like vacations or emergency expenses.
Liquidity	Relatively liquid with quick redemption similar to other arbitrage mutual funds; however, execution may take longer due to trading processes across markets. Market conditions can impact liquidity during volatile periods.	Among the most liquid investment options available, they allow easy redemption of units at any time with typically no exit load. Most liquid funds enable redemption within 24 hours, ensuring immediate access to cash without significant delays in processing withdrawals.
Use Case	Ideal for investors seeking stable, low-risk returns during volatile market conditions. Suitable for medium-term investors looking to exploit small market inefficiencies without direct exposure to stock market risks.	It is best for investors needing a safe place to park money while maintaining liquidity temporarily. It is also ideal for individuals with short-term investment needs or those looking for quick access to cash while earning slightly better returns than traditional savings accounts or fixed deposits.

Conclusion

Thus, an arbitrage mutual fund is a type of mutual fund that uses a market-neutral approach for generating returns off deviations in prices between the cash market and the derivatives market. These funds are regarded as low-risk vehicles that provide modest returns. There are better investments to make if one wants to reap high returns. However, considering conservative or volatility-minimising objectives, they can be integral to a well-diversified portfolio.

As for income-seeking investors, arbitrage funds may be helpful in a steady, relatively risk-free return. Yet, one should know that when risks are more minor, returns are also not substantially huge by various measures. Consider an arbitrage fund if you do not mind average returns and want to avoid market swings.

Frequently Asked Questions (FAQs)

What is an arbitrage fund?

An arbitrage fund is a type of mutual fund that seeks to profit from price discrepancies between the cash market and derivatives market for the same security. The fund manager buys the undervalued security and sells the equivalent overvalued security to lock in a low-risk profit.

How do arbitrage funds make money?

Arbitrage funds make money by exploiting small differences between the securities prices in the cash and derivatives markets. They buy securities in one market when the price is lower and sell them at a higher price in another market.

What returns can you expect from arbitrage funds?

Arbitrage funds generally provide modest but stable returns in the range of 5-7%* per year. The returns are lower than equity funds but higher than liquid or debt funds.

Are arbitrage funds risk-free?

No, arbitrage funds carry certain risks, such as market risk, execution risk, liquidity risk, etc., but the risks are relatively low compared to equity funds since the strategy is market-neutral.

What is the investment horizon for arbitrage funds?

Arbitrage funds are best suited for a medium term investment horizon of 6 months to 1 year. This allows enough time for price discrepancies to materialise in the markets.

Author: All Content is verified by SMC Global Securities.