- Date : 10/02/2023
- Read: 4 mins
An arbitrage fund locks in a profit in every trade from the pricing mismatch for the same security in two different markets. It carries low risk and offers the advantage of equity fund taxation.
Arbitrage funds are taxed as equity funds as they have an equity exposure of 65% or higher. But, arbitrage funds are supposed to be safe and are often compared with liquid funds. In this article, we will understand what arbitrage funds are, how they work, and whether they are safe.
What is an arbitrage fund?
It is an open-ended scheme investing in arbitrage opportunities. An arbitrage opportunity means taking advantage of different prices of the same security in two different markets. Arbitrage funds have a minimum investment of 65% in equity and equity-related instruments. As the equity exposure is 65% or higher, it is treated as an equity mutual fund from a taxation point of view.
Also Read: Arbitrage And Hedging: How Do They Differ?
How do arbitrage funds work?
An arbitrage mutual fund manager tries to take advantage of the pricing difference of the same instrument in two different markets. Let us understand this with the help of an example.
Let us assume that the shares of HDFC Bank Limited are trading at Rs. 1,500 in the cash market and at Rs. 1,520 in the futures market. An arbitrage fund manager spots the pricing mismatch of the futures trading at a premium. He will take advantage of this arbitrage opportunity by buying HDFC Bank shares from the cash market at Rs. 1,500 and selling the HDFC Bank futures at Rs. 1,520. In the process, the fund manager will lock in a profit of Rs. 20/per share in this trade.
On settlement, let us understand what can be the various pricing scenarios and how will the arbitrage fund benefit from this trade.
As we can see in the above table, irrespective of the HDFC Bank share price at the time of settlement, the arbitrage fund will pocket a profit of Rs. 20/share.
Also Read: Benefits Of Lump Sum Investment And How Women Can Go About It
Are arbitrage funds safe?
Now that we understand what arbitrage funds are and their investment strategy, the next question that comes to mind is whether they are safe and whether you should invest. We saw in the above section how an arbitrage fund locks in a profit in every trade. So, from a risk point of view, arbitrage funds carry low risk. The chances of earning negative returns from an arbitrage fund are low.
At the same time, the investors should temper their return expectation from arbitrage funds on the upper side. The amount of profit per share will vary depending on the spread available between the cash market and the futures market price of the security. Most of the time, the spreads are low as the mispricing of the same security in different markets doesn’t last for too long.
Arbitrage funds get better spreads when markets are very volatile. Some instances of these include the US subprime crisis (2008-09), the Greece debt crisis (2011-13), demonetisation (2016), Covid (2020), etc. During these periods, arbitrage funds did well. During other periods, when markets are either stable or moving linearly, the returns are low.
Apart from the equity component, arbitrage funds can have a debt component of up to 35% of total assets. The debt portion may carry credit risk. Hence, an investor should analyse where the arbitrage fund is investing in the debt component.
Also Read: Mutual Funds: What you Should Know Before Investing In Different Types Of Funds?
Should you invest in an arbitrage fund?
As an investor, are you looking to benefit from arbitrage opportunities? If yes, you may invest in an arbitrage fund. However, bear in mind that the returns will be low to moderate. If your investment time horizon is short (3 to 15 months), and if you are looking for favourable tax treatment, you may consider investing in an arbitrage fund. An arbitrage fund gets taxed as an equity fund as the equity component is 65% or higher. When choosing from the best arbitrage funds for investment, leave out those with high expense ratios. As mentioned earlier, since the returns from these funds are low, a high expense ratio will further eat into your returns. You cannot use arbitrage funds for long-term wealth creation.
Arbitrage funds are taxed as equity funds as they have an equity exposure of 65% or higher. But, arbitrage funds are supposed to be safe and are often compared with liquid funds. In this article, we will understand what arbitrage funds are, how they work, and whether they are safe.
What is an arbitrage fund?
It is an open-ended scheme investing in arbitrage opportunities. An arbitrage opportunity means taking advantage of different prices of the same security in two different markets. Arbitrage funds have a minimum investment of 65% in equity and equity-related instruments. As the equity exposure is 65% or higher, it is treated as an equity mutual fund from a taxation point of view.
Also Read: Arbitrage And Hedging: How Do They Differ?
How do arbitrage funds work?
An arbitrage mutual fund manager tries to take advantage of the pricing difference of the same instrument in two different markets. Let us understand this with the help of an example.
Let us assume that the shares of HDFC Bank Limited are trading at Rs. 1,500 in the cash market and at Rs. 1,520 in the futures market. An arbitrage fund manager spots the pricing mismatch of the futures trading at a premium. He will take advantage of this arbitrage opportunity by buying HDFC Bank shares from the cash market at Rs. 1,500 and selling the HDFC Bank futures at Rs. 1,520. In the process, the fund manager will lock in a profit of Rs. 20/per share in this trade.
On settlement, let us understand what can be the various pricing scenarios and how will the arbitrage fund benefit from this trade.
As we can see in the above table, irrespective of the HDFC Bank share price at the time of settlement, the arbitrage fund will pocket a profit of Rs. 20/share.
Also Read: Benefits Of Lump Sum Investment And How Women Can Go About It
Are arbitrage funds safe?
Now that we understand what arbitrage funds are and their investment strategy, the next question that comes to mind is whether they are safe and whether you should invest. We saw in the above section how an arbitrage fund locks in a profit in every trade. So, from a risk point of view, arbitrage funds carry low risk. The chances of earning negative returns from an arbitrage fund are low.
At the same time, the investors should temper their return expectation from arbitrage funds on the upper side. The amount of profit per share will vary depending on the spread available between the cash market and the futures market price of the security. Most of the time, the spreads are low as the mispricing of the same security in different markets doesn’t last for too long.
Arbitrage funds get better spreads when markets are very volatile. Some instances of these include the US subprime crisis (2008-09), the Greece debt crisis (2011-13), demonetisation (2016), Covid (2020), etc. During these periods, arbitrage funds did well. During other periods, when markets are either stable or moving linearly, the returns are low.
Apart from the equity component, arbitrage funds can have a debt component of up to 35% of total assets. The debt portion may carry credit risk. Hence, an investor should analyse where the arbitrage fund is investing in the debt component.
Also Read: Mutual Funds: What you Should Know Before Investing In Different Types Of Funds?
Should you invest in an arbitrage fund?
As an investor, are you looking to benefit from arbitrage opportunities? If yes, you may invest in an arbitrage fund. However, bear in mind that the returns will be low to moderate. If your investment time horizon is short (3 to 15 months), and if you are looking for favourable tax treatment, you may consider investing in an arbitrage fund. An arbitrage fund gets taxed as an equity fund as the equity component is 65% or higher. When choosing from the best arbitrage funds for investment, leave out those with high expense ratios. As mentioned earlier, since the returns from these funds are low, a high expense ratio will further eat into your returns. You cannot use arbitrage funds for long-term wealth creation.
