Arbitrage Funds: What Are They and How Do They Work?

Arbitrage funds are hybrid equity-oriented funds that simultaneously buy and sell assets from different markets to book profit. 

Meaning, these funds take advantage of the difference in stock price in two different markets. 

These funds are ideal for investors looking for safer avenues to invest in during volatile markets. 

Read along to find more. 

How Do Arbitrage Funds Work?

Arbitrage funds buy assets from one market at a certain price and sell the same assets at a different market at a higher price. Both ‘Buy’ and ‘Sell’ transactions take place on the same day. 

As per SEBI guidelines, these funds invest at least 65% of total assets into equity and equity-related instruments. 

Let’s take an example:

  • A stock of an XYZ company is trading at INR 500/unit on the Bombay Stock Exchange. 
  • The same stock is trading at INR 515/unit on the Bangalore Stock Exchange. 

There’s an opportunity to earn INR 15/unit profit without any risk. Fund houses will buy the units from the Bombay Stock Exchange and sell them at the Bangalore Stock Exchange. 

Arbitrage funds may also operate within the Spot Market and Futures Market. 

  • Let’s say a stock of an ABC company is trading at INR 1000/unit at the Spot market. Fund houses will buy these stocks and the transaction will settle on the ‘Spot’.
  • The same stock has a value of INR 1020/unit in the Futures market. Fund houses will lock the ‘Sell’ for that price on the same day, which will settle at a future date (a month later.)

After locking the profit, the stock price in both markets has no impact on the returns. In both scenarios, investors will earn the profit they have locked in the beginning. Therefore, these funds are immune to market volatility. 

Factors to Consider Before Investing in Arbitrage Funds

1. Risk vs Returns

Arbitrage funds carry comparatively lower risk than other equity funds. Since the profit will be locked, market volatility would be of no concern. 

In fact, these funds may deliver superior returns during a volatile market. There is a chance that the future price of the asset to be significantly higher during a volatile market. Investors may lock in more profit when the asset prices are aggressively updating. 

However, when markets are flat, the asset price difference might be negligible. The fund may deliver lower returns.

2. Investment Horizon

Arbitrage funds are ideal for 6 months to 2 years of investment horizon. The arbitrage opportunities can deliver superior returns in 6 or more months.

If you want to park a lumpsum amount for a while at a comparatively safer avenue, go with these funds.

Additionally, staying invested for more than 12 months will also be tax-efficient. Plan your investment horizon accordingly.  

3. Fund Manager Strategy

Fund managers are always on the lookout for arbitrage opportunities. They strategically pick up underlying assets to ensure profit.

Additionally, the fund also maintains a small allocation in debt/fixed-income securities to balance the returns. 

Arbitrage opportunities may not be abundant. A fund manager’s strategy makes all the difference in the returns of these funds. 

4. Expense Ratio

The expense ratio is a certain fee you have to pay to the fund house for managing your investments. 

As Arbitrage funds execute trade transactions every day, the expense ratio is often high. You may also be liable for a higher exit load if you redeem your investment between 30 to 60 days. 

Tax Implications on Arbitrage Funds

Arbitrage Funds follow equity taxation rules based on investment duration. 

  • You will have to pay a 15% tax on Short-term Capital Gains (Investments redeemed within 12 months.)
  • Long-term Capital Gains (Investments redeemed after 12 months) are taxed at 10% above 1 lakh.

Who Should Invest in Arbitrage Funds?

Arbitrage funds are ideal for investors wanting superior returns than debt funds, but at the same time lower risk compared to equity funds. 

Investors with higher tax brackets can benefit from better post-tax returns.

For aggressive investors, these funds can bring stability during volatile markets. While you are exploring high-risk equity funds, Arbitrage funds can be your safety net.

It is always advisable to take the opinion of your financial planner before investing in any funds. 

Conclusion

Ever since debt funds taxation changed, the demand for Arbitrage funds has increased.  

These funds can hold your portfolio together during market volatility. Investors with a low-risk appetite can invest in this category. However, note that the returns on these funds may not be as superior as other equity funds. 

If you find these funds appealing, financial advisors at VNN Wealth can help you analyze your portfolio. Give us a call to know if these funds fit your risk profile and financial goals. 

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