What's the concept of an arbitrage fund and how does it generate returns?

Arbitrage is one of the most effective ways to insulate against market volatility. An arbitrage fund buys equities in the cash market and simultaneously sells in the futures market, thus ensuring market neutrality for the investment.  In other words, it is a unique asset class by itself where returns are generated by capturing the pricing differential between the cash and the futures markets. It is also termed as a market-neutral fund where the returns are not going to be impacted by volatility in the market.

Is this the right time for investing in a derivative or arbitrage fund?

Yes, this the right time for an investor to enter into with a recommended time horizon of 6 months to 12 months. It's an ideal time to have some allocation in this kind of a product and de-risk the portfolio at current levels.

Will the current volatility in the market have any negative impact on the performance of arbitrage funds?

For any arbitrage fund, the following market conditions are beneficial  -- a bullish market and a volatile market.  While the fund performs very well in bullish markets, a volatile market gives it opportunities for early exit, thus enhancing the overall yield of the portfolio. However, a prolonged bear phase is not an ideal situation for this kind of product.   

How is an Arbitrage Fund different from an Income Fund both in terms of risk and returns?

In terms of returns, an arbitrage fund is better than an income product. An income product has a fixed yield-to-maturity while in an arbitrage product, the yields are better due to lower cost of carry and are usually in the range of 10-14%.

Secondly, the risk parameters are similar or lower than an income product.  An arbitrage fund does not carry any credit rating risk and interest rate risk, while the returns can be much higher than an income product. Added to this, a mutual fund arbitrage product enjoys all the tax benefits enjoyed by mutual fund products

Derivatives in India have more often been used for speculation purposes than for hedging and arbitrage. What are your views on this?

Both in India and the world over, derivatives have been widely used as a leverage product but as the trends are changing and the investors are maturing, the other tools like hedging and risk free arbitrage strategies are also being widely used.

What is your advice for a small investor in the current market scenario?

I would advise a small/retail investor to continue holding on to good fundamental stocks. He should not panic at these levels as we are into the last leg of the correction. Ideally if a small investor is unable to actively manage his investments, he should invest through mutual funds to diversify the risk.