When there is uncertainty in the market, certain investors may search for relatively stable asset classes with the additional benefit of tax advantages of equity investments. In such scenarios, arbitrage funds can be helpful. These are hybrid mutual funds that aim to generate gain by taking advantage of the price differential of securities between markets or segments. Although potential gains are not assured, arbitrage funds are suitable for conservative investors having a short term to medium term investment horizon. This article explains what arbitrage funds are, how they work, and the key advantages that they can offer.
What are Arbitrage Funds?
An arbitrage fund is a hybrid mutual fund that takes advantage of the inefficiency of the market. It buys and sells one security in two markets at the same time to take advantage of the price difference. For example, the fund buys a stock in the cash market and sells it in the futures market when the price in the futures market is higher. The price difference or the arbitrage spread is the potential gain.
As per SEBI rules, arbitrage funds are required to invest at least 65% of their corpus in equities and equity-related instruments. Despite equity exposure, the risk is not typically perceived to be high, as the buy and sell positions hedge each other.
How do Arbitrage Funds Work?
The core working of an arbitrage fund is to capitalise on the price difference of a stock on different markets. This is how it works:
- · The fund manager buys a stock in the cash market and sells the same stock in the futures market.
- · Arbitrage gain refers to the difference between the buying price and the selling price of the asset when traded on different markets.
- · On expiry, the positions are squared off, and the spread is realised.
- · There may be fewer arbitrage opportunities in times of low volatility.
- · The fund also invests its holdings in debt securities to ensure stability and liquidity.
Arbitrage funds are professionally managed and the potential gains they provide depend on market conditions.
Key Features of Arbitrage Funds
These funds have certain attributes that make them different from other mutual fund types. Some of these key features are listed below:
- · Reduced Risk: Hedged positions reduce market risk even with exposure to equity.
- · Short-term Goal: Generally suitable for investing capital for 3-12 months.
- · Tax-Effective: Considered as equity for taxation if a 65% equity allocation is maintained.
- · Volatility-based Gains: Opportunities increase during volatile market.
- · Debt Investment: Part of the funds may be invested in debt instruments for stability.
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Who Should Invest in Arbitrage Funds?
The suitability of arbitrage funds depends on your investment goals and risk tolerance. They can be chosen under the following situations:
- · You want to temporarily invest funds with improved tax treatment than debt.
- · You want to take advantage of market volatility without taking direct equity risk.
- · You are a conservative investor considering equity mutual funds for the first time.
- · You want to avoid conventional savings products that have unfavourable interest rates.
Benefits of Arbitrage
Arbitrage funds offer a unique value proposition, especially during volatile markets. Some of these potential benefits are as follows.
- · Capital Protection under Equity Taxation: They seek to provide relatively stable gains without assuming the directional risk of equity, while also seeking to capitalise on the equity tax treatment.
- · Reduced Market Risk: Since the buying and selling transactions occur simultaneously, market exposure is reduced.
- · Liquidity: They are open-end funds and are redeemable at NAV, which offers high liquidity to short-term investors.
- · May be Preferable for Short-Term Investing Period: If you prefer to invest idle funds for a short term, arbitrage funds can be suitable option.
- · Available Through SIP: You can also automate your investments through SIP investment, thereby making it simple to create short-term wealth without timing the market.
Risks and Considerations
Arbitrage funds carry minimal market risk, some of which are as follows.
- · Limited Arbitrage Opportunities: In stable markets, smaller price gaps can lower gains.
- · Operating Expenses: Continuous selling and purchasing can result in increased transaction costs and hence affect net gains.
- · Interest Rate Effect: Yields within the debt category can fluctuate with interest rate changes.
Thus, it is important to look through the past consistency of the fund and learn how the fund manager approaches various market periods.
Conclusion
Arbitrage funds are a preferable investment option for individuals who want reduced-risk exposure with the tax advantage of equity. Their structure enables them to perform well in volatile market conditions and yet conserve capital. If you are considering a short-term financial goal or simply want to invest extra funds, arbitrage funds can be considered as part of your investment strategy. Platforms like Axis MF offer these type of funds that may appeal to investors seeking stable returns with reduced market risk.
