What is Arbitrage Fund Definition and How They Work

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.

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. 

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.

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.

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. 

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.  

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.

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.

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.