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ULIP INSURANCE

What are Arbitrage Funds and How do they Work?

Karan Sharma Karan Sharma 03 February 2020

Arbitrage funds take advantage of changing prices of securities trading between different stock exchange.

Arbitrage Funds

When a particular equity trades on two different exchanges, there can be mispricing between the two due to economic volatility. An arbitrage fund works on the mispricing of such stocks in the spot and futures market. The price differences between the current and future security contracts generate maximum possible returns in an arbitrage fund. For Example: The fund manager simultaneously purchases equity in the cash market and sells it in futures/derivatives market. The difference in the cost price and the selling price is the return earned by the fund manager.

How does this fund work?

A fund manager speculates the price of an equity in the cash and futures/options market. Say, a stock trades at Rs. 1,000 in the cash market while the same stock is for Rs. 1,100 in the futures market. The fund manager will purchase the shares at a lower price from the cash market and sorts a futures contract to sell the shares at Rs. 1,100. When the prices coincides in the future, the fund manager will sell the shares in the futures market and generate a risk-free profit of Rs. 100 less than transaction costs. As an alternative option - the fund manager speculates the price to fall in the future, he/she will enter into a long contract in the futures market and short sell the shares in the cash market at Rs. 1,100. Post the expiry date, the fund manager will buy the shares in the futures market at Rs. 1,000 to cover his position to earn a profit of Rs. 100.

Who should invest in an Arbitrage Funds?

Arbitrage funds are suitable for investors looking for equity exposure with a low risk-appetite. An arbitrage fund makes profit low-risk buy-and-sell opportunities in the cash and futures market. Such funds follow CRISIL BSE 0.23% Liquid Fund Index as their benchmark as their risk level is at par with pure debt funds.

Features of Arbitrage Funds

The key features of arbitrage funds are:

  • Risk: Since the trade takes place between different exchanges, there is no counterparty risk involved in these funds. There is no exposure to equities as in the case of equity mutual fund. An arbitrage fund makes profit through low-risk buy-and-sell opportunities in the cash and futures market. Fund managers keep looking for arbitrage opportunities.
  • Return: Arbitrage funds provide reasonable profits, especially if the fund manager is highly skilled. On the basis of historical performance, arbitrage funds are known to offer returns in the range of 7% to 8% over 5-10 years. Arbitrage funds are the perfect blend of debt and equity in a volatile market. Also, there are no guaranteed returns in arbitrage funds.
  • Cost of Investment: Just like mutual funds, arbitrage funds charge an annual fee called expense ratio. Expense ratio is a percentage of the fund’s overall assets. The expense ratio includes the fund manager’s fee and fund management charges. Some funds have an exit load of 30 to 60 days.
  • Investment Horizon: Arbitrage funds are suitable for investors having a short to medium-term horizon (3 years to five years). Since there is an exit load involved, you should stay invested for at least 3-6 months. An arbitrage fund is highly dependent on the existence of high volatility. Thus, a lump sum investment is suitable over systematic investment plans.
  • Investment Objective: Arbitrage funds are suitable for short to medium-term financial goals. If you have extra income lying in your bank account, you can park these excessive funds to create an emergency fund and earn higher returns on the same. Overall, an arbitrage fund is a suitable addition to your investment portfolio.
  • Tax: Arbitrage funds are treated as equity funds for taxation. STCG (short term capital gains) tax of 15% is applicable if you stay invested for a period of less than one year. LTCG (long term capital gains) tax is applicable for a period of more than one year. LTCG in excess of Rs.1 lakh a year is taxed at the rate of 10% without the benefit of indexation.

Arbitrage Funds in India

Here are the top 5 arbitrage funds in India:

Nippon India Arbitrage Fund

Investment ObjectiveTo generate income by taking advantage of the arbitrage opportunities that potentially exists between cash and derivative market and within the derivative segment along with investments in debt securities & money market instruments
TypeHybrid: Arbitrage
BenchmarkNifty 50
AUMRs. 10223.57 Cr
Fund ManagerAnand Devendra Gupta
Return Rate 1 Yr6.28%
Return Rate 3 Yrs6.27%
Return Rate 5 Yrs6.64%

Kotak Equity Arbitrage Fund

Investment ObjectiveTo generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and derivatives segment of the equity market, and by investing the balance in debt and money market instruments
TypeHybrid: Arbitrage
BenchmarkNifty 50
AUMRs. 17362.55 Cr
Fund ManagerRukun Tarachandani , Hiten Shah
Return Rate 1 Yr6.19%
Return Rate 3 Yrs6.16%
Return Rate 5 Yrs6.50%

Edelweiss Arbitrage Fund

Investment ObjectiveTo generate income by predominantly investing in arbitrage opportunities in the cash and derivative segments of the equity markets and the arbitrage opportunities available within the derivative segment and by investing the balance in debt and money market instruments
TypeHybrid: Arbitrage
BenchmarkNifty 50
AUMRs. 3879.13 Cr
Fund ManagerDhawal Dalal, Bhavesh Jain
Return Rate 1 Yr6.26%
Return Rate 3 Yrs6.15%
Return Rate 5 Yrs6.59%

UTI Arbitrage Fund

Investment ObjectiveTo generate capital appreciation through arbitrage opportunities between cash and derivative market and arbitrage opportunities within the derivative segment and by deployment of surplus cash in debt securities and money market instruments. However, there can be no assurance or guarantee that the investment objective of the scheme would be achieved
TypeHybrid: Arbitrage
BenchmarkNifty 50
AUMRs. 3251.71
Fund ManagerRajeev Gupta, Amit Sharma
Return Rate 1 Yr6.31%
Return Rate 3 Yrs6.11%
Return Rate 5 Yrs6.44%

L&T Arbitrage Opportunities Fund

Investment ObjectiveTo generate reasonable returns by predominantly investing in arbitrage opportunities in the cash and derivatives segments of the equity markets and by investing the balance in debt and money market instruments
TypeHybrid: Arbitrage
BenchmarkNifty 50
AUMRs. 772.75
Fund ManagerAlok Ranjan, Venugopal M, Praveen Ayathan, Jalpan Shah
Return Rate 1 Yr6.11%
Return Rate 3 Yrs6.04%
Return Rate 5 Yrs6.43%

Conclusion

Arbitrage funds are considered a suitable investment option. It is advisable to keep one arbitrage fund in your investment portfolio.

Karan Sharma
Written by Karan Sharma
Content Specialist and Strategist, foolishly creative and always ready for a game of 'Call of Duty'.