Why Arbitrage Funds Are Better During Volatile Times

Mutual funds are one of the most popular investment options preferred by many. An investor has the option to invest in several kinds of mutual fund schemes that are available in the market. Different funds cater needs of different investors.

While selecting a fund to invest in, there are several things that need to be considered. One of the things that play an important role while making this decision is the overall market trend. Some funds perform better when the market is trending and volatile, like arbitrage funds.

Data shows arbitrage funds tend to outperform other funds and provide better returns when the market is unable to find a particular direction. Although arbitrage funds may be a good investment option, it is important to know what they are and how they work before investing in them.

What are Arbitrage Funds

Arbitrage refers to the act of buying and selling a security in different markets at the same time in order to benefit from the price discrepancies that may be present in two or more markets. As the name suggests, arbitrage funds use the money received from investors to arbitrage in the financial markets.

These are hybrid mutual fund schemes that capitalize on the different prices quoted in the different capital market segments of the same underlying assets, with an aim to generate arbitrage profits. Arbitrage funds can invest in debt and money market instruments as well.

How Do Arbitrage Funds Work

In order to understand how an arbitrage mutual fund works, it is necessary to know what arbitrage is. Arbitrage is a trading strategy in which a security is bought in one market while it is simultaneously sold in another market. This helps capitalize on the difference between the prices in different markets.

At times, there are slight discrepancies in price where the same asset may be priced slightly lower in one market and higher in another. Since the prices need to be closer to each other, an arbitrage fund can benefit by selling the security in the market where it is priced higher and purchasing the security in the market where the price is lower. The difference between the two prices is the profit that the fund can generate.

Suppose, the price of XYZ stock is Rs 500 in the cash market and its futures contract is trading at Rs 507. Since the cash and futures market prices need to be the same on the day of expiry, a fund manager can benefit by using arbitrage. The fund manager can buy the stock in the cash market while selling the future contract. On the day of expiry, the positions are squared off and the fund generates a profit of Rs 7 for each stock.

Why Arbitrage Funds Became Popular

Arbitrage funds have gained in popularity since the structure of mutual funds was changed in the 2014-2015 financial budget. Arbitrage funds are classified as equity funds and are a popular short-term investment option. Since the long-term capital gains benefits can be availed after just one year, many investors look at it as a good short-term investment option. High net-worth individuals often park their money in these funds as they can benefit from the volatility and offer relatively higher returns than liquid funds. Moreover, arbitrage mutual funds are comparatively risk-free as even drastic price movements can help the fund generate returns.

As an investor, there are several options available to invest. During volatile times, investors are often confused while making a decision to park their money. Allocating a part of your investment capital in an arbitrage fund can be helpful, especially during uncertain times. The high liquidity, low-risk and stable returns make arbitrage funds a popular investment option.

FAQs

Is it a good time to invest in arbitrage funds?

Investing in an arbitrage fund may be beneficial amid the era of rising interest rates. This might lead to more volatility in the financial markets, which is beneficial for funds looking for arbitrage opportunities.

Do arbitrage funds have lock-in period?

Since arbitrage funds are classified as equity funds, there is no lock-in period.

What is the risk in an arbitrage fund?

Arbitrage funds are relatively low-risk funds. However, the returns might also be lacklustre if no arbitrage opportunities are available in the market.

Is arbitrage a good strategy?

Arbitrage is a good strategy to capitalize on price discrepancies and is especially helpful during volatile market conditions.