Arbitrage Funds – Meaning, Benefits, and How It Works

Investments in mutual funds involve some balance between risk and return. However, with an arbitrage fund, there’s an option to achieve a relatively low risk compared to exposure to equity markets. It makes returns from differences in prices in any scenario. Now, let’s explore the details of how it works, what the features are, and how this can be beneficial to add to your portfolio.

What is an Arbitrage Fund?

Arbitrage Fund Meaning: An arbitrage fund is that type of mutual fund, which exploits price differences for securities in different markets or market segments. The arbitrage funds aim to benefit from this difference by purchasing at the low price in one market and selling at the high price in another to generate return. These funds primarily focus on equities and derivative instruments but may hold debt instruments or cash equivalents to draw the balance between risk and liquidity.

Arbitrage funds are one of the lowest risk avenues for equity exposure as they hedge their positions. So, they’re good enough for conservative investors too to gain from the equity market with minimum risk.

How Does an Arbitrage Mutual Fund Work?

Here’s how arbitrage funds operate:

Identifying Opportunities:

The fund managers identify price differences between the current market price of a stock, known as the spot price, and the future price in the derivatives market.

Executing Trades:

The fund simultaneously buys the stock in the cash market and sells it in the futures market, locking in the price difference as profit.

Hedging Risk:

Since both buy and sell positions are taken, the risk from market fluctuations is minimized. Even if the market moves in an unpredictable manner, the net exposure of the fund remains negligible.

Earning Returns:

When the futures contract expires, the fund sells the stock in the cash market and settles the futures contract, realizing the difference in price as a gain.

During periods of market volatility, arbitrage funds often perform well due to increased price differences across markets, creating more profit opportunities.

Key Characteristics of Arbitrage Mutual Funds

• Low Risk: Hedging protects against significant market downturns.
• Equity Taxation: These funds enjoy the tax benefits of equity funds, making them favorable compared to debt funds.
• Liquidity: A portion of the portfolio is held in cash or debt instruments to manage redemption requests efficiently.
• Market-Dependent Returns: Returns rely on the availability of arbitrage opportunities, which increase during volatile markets.
• Diversification: Arbitrage funds invest across sectors, providing diversification.
• Short-Term Suitability: Ideal for short- to medium-term investment goals due to stable returns.

Why Invest in Arbitrage Mutual Funds?

• Low Volatility: Hedged positions make them safer for risk-averse investors.
• Tax Efficiency: Gains held for over a year are taxed at favorable rates.
• Volatility Benefits: Perform better in volatile markets, offering higher returns.
• Short-Term Option: Suitable for parking surplus funds temporarily.
• Hedged Equity Exposure: Benefit from equity markets with minimal risk.
• Alternative to Fixed Deposits: Post-tax returns are often better than traditional fixed-income options.

Considerations Before Investing

• Market Volatility: Returns depend on volatility-driven arbitrage opportunities.
• Expense Ratio: Choose funds with a lower expense ratio for better net returns.
• Investment Horizon: Suitable for short- to medium-term goals. For long-term growth, consider equity-oriented funds.
• Tax Implications: Evaluate the tax benefits in comparison to other options.
• Liquidity Needs: Ensure the fund aligns with your liquidity requirements, considering potential exit loads.
• Performance History: Analyze the fund’s track record across market cycles.
• Fund Manager Expertise: Success depends heavily on the manager’s ability to identify and act on arbitrage opportunities.

Conclusion

Arbitrage funds provide a balanced approach to investing, combining the safety of debt instruments with the tax benefits of equity funds. They are specifically suited for conservative investors or those seeking short-term parking of funds. However, as with any investment, understanding the fund’s features and market conditions is essential before investing.

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