What are arbitrage mutual funds?
An arbitrage fund is defined as a mutual fund that leverages the price difference in the cash and derivatives market to make a profit. In other words, the fund buys stock at regular cash rates and simultaneously sells them in the futures and derivatives market where the rates are slightly higher, or vice versa, and pockets the difference. These are also known as equity- oriented hybrid funds because they usually invest a large portion of the portfolio in equity and a part in the debt securities.
How it works:
For instance, many investors might feel that a particular stock which is valued at Rs 100 per share today is likely to go up over the course of the month. In which case, a futures contract, where you are betting on the price going up a month down the line, would be far more valuable. So an arbitrage fund would buy the stock at spot or current price, and immediately sell them in the futures market, where the price is slightly higher. This difference between spot and futures prices thus becomes a profit for an arbitrage fund.
Because these price differences are usually very small, a sizeable number of transactions are needed in order to make a profit. Arbitrage funds make sense for investors who are keen to profit from the stock market without too much risk exposure. Interestingly, these are the only funds with low risk that flourish when the market is volatile, leading to uncertainty among investors, and a rise in futures prices. During a stable period, however, the difference between futures and spot prices are minimal because investors don’t think the prices will fluctuate much over the month. Given the lack of profit during stable periods, the fund might invest in the bond market, which are far less profitable compared to the equity market.
Because these securities are bought and sold almost simultaneously, the risks associated with long term investments don’t apply. Most arbitrage funds park a lot of their corpus in debt, which is seen as reasonably stable. However, despite the relatively low risk compared to the equity market, it is important to keep in mind that these mutual funds have unpredictable returns, and have substantial transaction costs. This transaction cost is mainly due to the larger number of transactions that an arbitrage fund must make to generate reasonable returns.
If you hold your shares in an arbitrage fund for more than a year, any profit you make is taxed as capital gains, which is much lower than the regular income tax. Before you invest in these funds, or any other, you must map them against your investment goals and risk tolerance and see that they are aligned.
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