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Arbitrage Funds

The term ‘arbitrage’ means the simultaneous buying and selling of securities in two different markets in order to gain from the price difference for the same asset. Arbitrage fund is a kind of mutual fund that is best-suited for investors looking to profit from volatile markets without taking on too much risk. Now, prior to investing in one, it is necessary to understand how they work and whether they are a right fit for your portfolio. Here is a look at everything there is to arbitrage funds:

How Arbitrage Funds work

Profits in case of an arbitrage fund are realized through the purchase and sale of securities on different exchanges. Arbitrage funds leverage the price differential in the cash and derivatives market for the purpose of generating returns. Instead of buying stocks and then selling them after the price has gone up, an arbitrage fund purchases stock in the cash market and concurrently sells that interest in the futures market.

Things to Consider as an Investor

Prior to investing in an arbitrage fund, here are some important points that investors need to take note of:

  • Low risk: Given that trade takes place on the stock exchange, it must be noted that there is no counterparty risk to these funds. Even as the shares are being bought and sold in cash and futures market, there isn’t any risk exposure to equities. However, when more and more people begin trading in arbitrage funds, the spread between cash and future market prices reduces, which could possibly leave little for the investors.
  • Investment horizon: Investments in arbitrage funds are best-suited for individuals that have a short to medium term horizon of three to five years. Since exit loads are imposed, it is advisable to consider investing in arbitrage funds only when one is prepared to remain invested for at least three to six months.
  • Returns: The aim of the fund manager is to generate alpha by making use of the price differentials. Historically, the past returns of such funds have been 7-8% over a period of five to ten years. Such funds provide a good opportunity to earn moderate earnings. However, investors should remember that there is no assurance about the returns.
  • Cost: Cost is an important factor that arbitrage fund investors need to take into consideration. Such funds charge an annual fee - referred to as expense ratio - in the form of percentage of the fund's assets. The fee is inclusive of the fund manager fees as well as management charges. As a result of frequent trading, arbitrage funds attract higher expenses and have a high turnover ratio. In addition to all this, the fund charges an exit load, which can further hamper the returns.
  • Taxability: For the purpose of taxation, arbitrage funds are treated similar to equity funds since they maintain an average exposure of more than 65% in equity. If an individual stays invested for up to 1 year, the short-term capital gains (STCG) shall be taxed. The tax on STCG is at the rate of 15%. In case the individual prefers to remain invested for a period of over 1 year, the gains that he or she earns will be referred to as long-term capital gains (LTCG). The tax on LTCG is at the rate of 10%, without indexation benefit.

Role of Arbitrage Fund Manager

The primary responsibility of arbitrage fund managers is to buy stocks in cash and sell in futures market - the difference is what the investors get as returns. The managers therefore look to capitalize on the market inefficiencies with the intent of generating profits for the investors. The fund managers cannot short the stocks, and thus resort to look out for deals that allow buying in cash market and selling in futures. Seeking such opportunities is what fund managers involved with arbitrage funds do. The individual does not purchase shares, which he or she cannot short in futures. It should be noted that though the manager is buying and selling shares in cash and futures market, there is no risk exposure to equities, which is the case with other diversified equity mutual funds.

Top Arbitrage Funds in India

According to a report by The Economic Times, the top arbitrage funds to invest in India for the year 2019 are Kotak Equity Arbitrage Fund and Reliance Arbitrage Fund.

  • Kotak Equity Arbitrage Fund: The scheme’s investment objective is to generate capital appreciation and income by primarily investing in arbitrage opportunities in the cash and derivatives segment of the equity market. The balance is parked in debt and money market instruments. However, there is no guarantee that the objective of the scheme shall be realized.

Minimum Investment Amount

  • Initial Investment: Rs. 5000 and in multiples of Re.1 for purchase and for 0.01 for switches
  • Additional Investment: Rs.1000 and in multiples of Re.1
  • Ideal Investments Horizon: 3 months and more

Click to know more about Asset allocation under normal circumstances

Click to know more about Asset allocation under defensive circumstances

Source: Kotak Mutual Fund

  • Reliance Arbitrage Fund: The scheme’s investment objective is to generate income by making use of the arbitrage opportunities. This can potentially exist between cash and derivative market and in the derivative segment along with investments in money market instruments and debt securities.

Minimum Investment Amount

  • Minimum Investment: Rs. 5000 and in multiples of Re. 1 thereafter

Click to know more about Asset allocation under normal circumstances

Click to know more about Asset allocation under defensive circumstances

Source: Reliance Mutual Fund

FAQs on Arbitrage Fund

What is meant by arbitrage fund?

Arbitrage funds are a type of mutual fund that are suitable for investors looking to profit from volatile markets without taking on too much risk. Fund managers of arbitrage funds will buy stock in the cash market and concurrently sell that interest in the futures market.

How does an arbitrage fund work?

Profits from an arbitrage fund are realized through the buying and sale of securities on different exchanges. Such funds leverage the price differential in the cash and derivatives market in order to generate returns. Rather than purchasing and then selling them after the price has gone up, the fund manager will buy stock in the cash market and concurrently sells that interest in the futures market.

Which arbitrage fund is good?

According to a report by The Economic Times, Kotak Equity Arbitrage Fund and Reliance Arbitrage Fund have been listed as the top arbitrage funds to invest in India for the year 2019. Both of the funds are open ended schemes that invest in arbitrage opportunities, and their risk profile is moderately low.

Are arbitrage funds safe?

Arbitrage funds are normally considered safe, and carry little risk. The fund managers look to reduce the risk of equities by hedging against the derivatives. In the case of arbitrage funds, market volatility does not mean more risk for the investor. In fact, arbitrage opportunities exist only when the markets are uncertain or not stable.

What is an example of arbitrage?

Shares of ABC Co. Ltd. are trading at Rs. 600 each on the cash market and at Rs. 800 on the futures market. Through the buying of shares from the cash market and selling on the futures market, the profit generated is Rs. 200 per share.

How is arbitrage taxed?

Since arbitrage funds maintain an average exposure of more than 65% in equity, they are taxed just like equity funds. The tax on short-term capital gains is levied at the rate of 15%, while the tax on long-term capital gains is at the rate of 10%, without indexation benefit.