What is Arbitrage Fund?

By its very nature, arbitrage funds involve exploiting price differences between two markets. These price differences exist in the first place because of shifts in supply and demand. Consider buying something at a lower price in one market, let's say the cash market, then selling it for slightly more in another, say the futures market.

The cash market is the one in which stocks are traded for immediate delivery. On the other hand, the futures market deals with contracts that commit to buying or selling an asset at a pre-decided price on a future date.

Now, whenever there is a price mismatch between these two markets, an arbitrage opportunity arises, and it's also the moment when the best arbitrage funds swing into action.

 

How Arbitrage Funds Work

Arbitrage funds are mutual funds that primarily invest in arbitrage opportunities. The fund managers purchase shares in the cash market and, at the same time, sell the same in the futures market if there is a price difference. Thereafter, when the prices normally converge by the contract's expiration, the fund earns a profit from the spread.

Arbitrage funds are unique as they work on the market's inefficiencies, not market trends. This makes them relatively low-risk as compared to equity funds. Besides, as they invest a portion of the portfolio in debt instruments, the best Arbitrage funds provide a buffer against volatility.

 

Benefits of Arbitrage Funds

Here are the key benefits of the Aribitrage funds you must know as an investor and trader:

• Lower Risks: Arbitrage funds often carry little risk for investors because each security is purchased and sold simultaneously.
• Low Tax: Although these funds often invest in equities, they are considered balanced or hybrid funds since they invest in both debt and equity. As a result, they are taxed as equity funds.

 

What Are the Risks of Arbitrage Funds?

Arbitrage funds are considered much safer than most equity-based investments but are not completely risk-free.

• Market Volatility: You enjoy arbitrage opportunities only in volatile markets or when there are price differences. There are fewer opportunities for stable markets for arbitrage, and hence, the potential of returns is also less.
• Liquidity Risks: Trades may not be easy to go through when you do not have adequate trading activity in the futures market.
• Tax Implications: Equity funds are taxable; if you redeem within one year, short-term capital gains can be taxed at a higher rate.

 

How Are the Returns on Arbitrage Funds Like?

The best Arbitrage funds give slightly better returns than liquid funds but fluctuate with market conditions. The returns are more enticing in highly volatile times when the price gaps between different classes of securities widen. However, during stable phases, the returns are not as great as those on fixed deposits or other low-risk investments.

 

Conclusion

Arbitrage funds are the right mix of safety and good returns, which works well with conservative investors. Though not risk-free, they may help balance your portfolio, provided you understand the dynamics of investments. For first-time and seasoned investors, there is every reason to have an arbitrage fund in their investment toolkit.