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The financial market is ever-volatile, and the probability of losses is quite high. It is quite impossible to earn attractive profits unless investors have a well-planned strategy to trade. Hence, wealth-aspiring investors are always on the lookout for new strategies and techniques to navigate through the complexities of the market.
One such strategy to earn profits in the financial market is arbitrage. Today’s article talks about the concept of arbitrage in mutual fund investments.
What is arbitrage in finance?
Arbitrage is an investment strategy for making profits using the price differences of securities. Investors use the difference in prices of the same security between two markets, two exchanges or two different contracts to make profits under the arbitrage technique.
Arbitrage is considered one of the most solid profit-earning techniques in a volatile market. However, it requires a thorough understanding of the security and constant supervision to monitor price fluctuations in different markets.
How do arbitrage funds work in the mutual fund market?
Arbitrage funds, also called equity arbitrage funds, are mutual fund schemes investing a majority of funds in equities and making profits through arbitrage.
The fund manager of such funds keeps a constant watch on the security’s price to make profits from inconsistencies and inefficiencies in different markets. The objective of such funds is to use differential pricing in cash markets and derivative markets. Similarly, securities also have price differences in different exchanges, which helps in making profits.
Let’s consider two examples to understand better:
Case 1: Take the example of shares of Infosys Ltd. As of 28 Feb 2024, the shares are trading at ₹1,674.85 on BSE and ₹1,675.75 on NSE.
The mutual fund manager buys 100 shares of Infosys on BSE at ₹1,674.85 and sells all 100 of them on NSE at ₹1,675.75, earning ₹0.90 per share and making an overall profit of ₹90.
Case 2: Take the example of shares of Godrej Properties Ltd. As of 28 Feb 2024, the share price on the NSE spot market was ₹2,435.30, and the NSE future market was ₹2,451.00.
The mutual fund manager bought 100 shares in the spot market and sold them in the futures market, making a profit of ₹15.7 per share and ₹1,570 on the overall transaction.
Features and benefits
- Arbitrage funds are equity-based, with over 65% of the overall investment in equities. The remaining fund is invested in liquid funds like short-term debts and bonds.
- Arbitrage funds work well in a volatile and unstable market where price differences are frequent and evident.
- Fund managers of such funds think differently. Their focus is more on tracking price changes while making investment decisions rather than fundamentally analysing stocks.
- Arbitrage fund returns are usually higher as compared to fixed deposits or liquid funds (Liquid funds invest in short-term liquid debt funds). The choice between arbitrage funds vs liquid funds and fixed deposits mainly revolves around the investor’s objectives, liquidity requirement and risk tolerance.
Talking about the risks involved with arbitrage funds, the primary risk of investing in financial markets is the uncertainty and volatility. However, this factor contributes to the profits of arbitrage funds, hedging the risk. Arbitrage funds are also hybrid, but, the risk associated with debts is almost negligible since a majority of the fund goes to equities and is arbitraged.
Why should you invest in arbitrage funds?
You should invest in an arbitrage fund if you want to benefit from a volatile market without exposing yourself to high degrees of risk. Also, investing through a mutual fund gives investors the benefit of relaxing while the fund manager tracks the securities to arbitrage them.
Despite a portion of the fund being invested in assets apart from stocks, the arbitrage fund’s taxation is on par with equity funds. They are taxed during redemption, either under short-term capital gains or long-term capital gains, based on the duration of holding the investment.
Bottomline
An arbitrage mutual fund is an ideal choice for those looking at making quick profits in the short-term, with low risk. These funds have less to offer in a stable market, as price differences are seldom available.
However, investing in an arbitrage fund in a volatile market can help investors make high profits. The capacity of the fund manager is crucial here since they must track the security closely. Hence, be sure to thoroughly assess the mutual fund company and its previous performances before making your investment.
FAQs
Considering the returns on investment, arbitrage funds may seem more attractive than fixed deposits. FDs are also liable for TDS, which is not applicable to arbitrage funds. However, arbitrage funds, though safe, still play in the equities market, making them slightly riskier than FDs.
The primary disadvantage of arbitrage funds is that they cannot perform well in a stable market. Besides, even when the market is volatile, the price difference between the two markets may not be very high, leading to a limited profit potential.
No, arbitrage funds are not tax-free. They are taxed similarly to equity funds. Short-term capital gains are taxed at 15%, and long-term capital gains above ₹1 lakh on arbitrage funds are taxed at 10%.
Arbitrage trading is not very risky. It is a hedging strategy to mitigate risk in a volatile market. However, an arbitrage fund carries liquidity risk. A fund manager can benefit from arbitrage only when the position is squared off. Finding a counterparty to square off the position may not be easy in a volatile market.
Some popular arbitrage funds in India are:
Invesco India Arbitrage Fund, Edelweiss Arbitrage Fund, Kotak Equity Arbitrage Fund, Tata Arbitrage Fund, Nippon India Arbitrage Fund, Axis Arbitrage Fund, Aditya Birla Sunlife Arbitrage Fund, etc