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All investments are prone to different risks and this hold true for mutual funds too as they are prone to market risk. However, some types of mutual fund schemes do offer a balance between risk and return. One of these schemes are Arbitrage Funds, a type of hybrid scheme that offers conservative investors an alternative to investing in pure equity or pure debt schemes.
Read on to know more about arbitrage funds definition, features, benefits and how they work to help you decide if they are the right investment option for you.
What are Arbitrage Funds?
Arbitrage Funds are a type of hybrid mutual fund that invests primarily in equities and equity-derivatives simultaneously. This allows the scheme to leverage the price differential of individual stocks on the equity and futures markets to generate investment returns. As a result, arbitrage funds generate higher returns for investors when markets are volatile resulting in higher preice differential between the equity and derivatives markets.
How to Arbitrage Funds Work?
Arbitrage funds are unique as their profits are generated through price differences in the cash and future market. The difference in selling and cost prices gives you the return you earn from these mutual funds.
Let’s understand this through an example:
Supposing you purchase equity share of a company XYZ. XYZ trades in the cash market at Rs 1000 and in the future market at Rs 1100. By the month end, when the stock reaches the future price, the fund manager will sell the shares in the market to generate a profit of Rs 100.
However, if the fund manager speculates that the price might fall in the future, they might enter into a different type of futures market contract know as a short-sell. They will short-sell the shares in the cash market at Rs 900. Upon the expiry, he will buy the units in the futures market at Rs 900 to cover up his position and yield a profit of Rs 100.
Alternatively, the fund manager may also purchase an equity share in National Stock Exchange (NSE) and sell the same at a higher price in the Bombay Stock Exchange (BSE) to generate a risk-free return.
However, such transactions are not risk-free. If there is minimal or no volatility in markets, the scheme will be unable to generate a profit.
Benefits of Investing in Arbitrage Funds
Here are the benefits you can get by investing in arbitrage funds:
1. Low Risk:
Arbitrage funds might be the right choice if you consider yourself a conservative investor. This is because there’s no counterparty risk in these funds when they are traded on the stock exchange. In other words, there is no net exposure to equities as buying and selling in the cash and futures market occurs simultaneously.
2. Taxation:
Arbitrage funds in India primarily invest in equities and equity derivatives. So, they are regarded as equity-oriented hybrid funds. Consequently, they are taxed as per equity mutual fund rules. As per existing mutual fund taxation rules, an investor holds shares in an arbitrage fund for more than a year, then any profits are tax-free up to Rs. 1 lakh in a financial year. In case of profits from scheme units held for less than 1 year, a flat rate of 15% tax rate is applicable.
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3. Managed by Fund Managers:
Most individuals do not begin investing as they think they don’t have the knowledge that is required to invest. The benefit of arbitrage mutual funds is that these funds are managed by fund managers. They buy the best assets in the market according to their expertise and your investment preference and objectives. Thereby, investment in arbitrage funds is effortless; at the same time, an investor can reap the benefits of the expertise of the fund managers.
3. Managed by Fund Managers:
Most individuals do not begin investing as they think they don’t have the knowledge that is required to invest. The benefit of arbitrage mutual funds is that these funds are managed by fund managers. They buy the best assets in the market according to their expertise and your investment preference and objectives. Thereby, investment in arbitrage funds is effortless; at the same time, an investor can reap the benefits of the expertise of the fund managers.
Drawbacks of Investing in Arbitrage Funds
Apart from offering a range of investment benefits, arbitrage funds have their own drawbacks. These include:
1. Negatively Affected by Demand:
The increased demand does not have a positive impact on arbitrage mutual funds. This means that as more people start investing in arbitrage funds, the opportunities would diminish with it. In addition, the cost price will diminish due to a spread between futures and the cash market, ultimately reducing the opportunities for arbitrage fund investors.
2. Pay-out is Unpredictable:
Arbitrage mutual funds offer little reliability when it comes to payouts as the net asset value (NAV) of these mutual funds might not increase fast. As a result, these funds are not very profitable when operating in stable markets. If there aren’t sufficient profitable arbitrage trades available, it might temporarily become a bond fund.
When it comes to that, excessive time in bonds can significantly reduce their profitability, so actively managed equity funds can outperform arbitrage funds in the long run.
3. Expense Ratios are High:
The high number of buying and selling needed to get successful arbitrage funds can make investment costs higher than many other types of mutual funds including most actively managed equity mutual funds. This potentially higher cost results in a high total expense ratio for the mutual fund scheme.
Things to Consider Before Investing
1. Expected Returns:
Arbitrage funds might not be the right choice if you are looking for high returns. This is because you might earn moderate returns when investing in arbitrage funds. Arbitrage funds generate returns from the price difference and opportunities available. Hence the returns are low if you are not in the long haul.
2. The Function of the Fund Manager:
The fund manager plays a significant role in arbitrage mutual funds. Their role is to identify arbitrage opportunities in the market and leverage them to give the investor their ideal returns. Therefore, it’s essential to choose a good fund manager who has the expertise, and correct management style to give you what you are looking for.
3. Expense Ratio:
As mentioned before, arbitrage mutual funds are managed by fund managers, for which they charge fees. As these types of mutual funds make hundreds and even thousands of trades daily, their expense ratio can be quite high, which can result in lower net returns from the investment.
As a potential investor you need to consider all these factors carefully before making the investment.
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Frequently Asked Questions (FAQs)
Q. Are arbitrage funds safe to invest in?
A. It is advisable to read the policy terms and conditions to know about the exclusions of the plan. In general, pre-existing diseases, intentional self-injury, or intoxication may not be covered under a standard health plan.
Q. Can arbitrage funds give negative returns?
A. Yes, they can. But the chances of low returns decrease significantly if you invest systematically such as through a systematic investment plan (SIP) and stay invested for periods of 3 years or longer.
Q. How can you evaluate arbitrage funds?
A. The expected returns and expense ratios help evaluate arbitrage funds. If you are earning expected returns after deducting the management fees, it’s a financially wise choice.
Q. Can arbitrage funds levy exit fees?
A. Some arbitrage funds can levy exit fees known as exit load to discourage investors from exiting. However, in case the investor stays invested for a pre-determined period, exit load becomes nil.
Q. How long should I invest in arbitrage funds?
A. Investing in arbitrage funds for at least six months is advised to ensure you don’t earn negative returns. However, as in the case of any equity-oriented investment, an investment period of 3 years or longer is advisable.
Sources:
https://economictimes.indiatimes.com/mf/analysis/best-arbitrage-mutual-funds-to-invest-in-2022/articleshow/88444771.cms?from=mdr
https://www.fisdom.com/arbitrage-mutual-funds/
https://www.livemint.com/money/personal-finance/despite-low-returns-arbitrage-funds-make-sense-for-some-investors-11609769366501.html
https://cleartax.in/s/arbitrage-funds
https://www.dspim.com/learn/articles/mutual-fund-advanced/what-are-arbitrage-funds-who-should-invest-in-these-funds
https://www.forbes.com/advisor/in/investing/what-are-arbitrage-mutual-funds/
https://economictimes.indiatimes.com/definition/arbitrage-fund/
ARN No : May23/Bg/07
