Arbitrage Fund Investment Guide: Everything you Need to Know

  • Akshatha Sajumon
  • 12 Jan
  • 8 minutes

Investors who are risk averse often invest in short-term mutual funds or bank deposits, the ones with definite returns, or at least minimal damage to their savings. Arbitrage funds are all the rage among this group for mainly two reasons, reasonable predictability at low risk, and post-tax returns. In the previous year, arbitrage funds recorded an average return of 4.2%, while liquid funds category was recorded at 4%. That’s just not it, an average Arbitrage fund can yield returns up to 8% over five to ten year in tenure.

What is an Arbitrage Fund?

An Arbitrage fund is a kind of mutual fund that leverages price differential in the cash and derivatives market to yield returns. In other words, it is the price difference between current and future securities. To do so, an arbitrage fund manager buys securities in the cash market to sell them in the future or derivatives market, and the difference in the two determines your short-term capital gains.

How do they work?

Arbitrage funds make use of the opportunities, such as the mis-pricing of stocks in the stock market. Returns are determined by the difference between buying and selling price of securities, irrespective of the subsequent price changes in the cash and futures market (expensive than the cash market because of a cost to carry & hold).

For example, a fund manager buys a stock in the cash market at INR 1200, and its value is INR 1250 in the futures market. He can buy it at INR 1200 in the cash market and sell at INR 1250 in the futures market to make a profit. Now, on the last day of F&O expiry, the two markets will converge at one price. There could be three scenarios to determine your profit:

The price goes up to INR 1,300, and in this you would make INR 100 in the cash market, while losing INR 50 in the futures market, making your net profit to be INR 20. If the price goes down to INR 1,100. At that point, you lose INR 100 in the cash market, while making INR150 in the futures market. Your profit is INR 50. If the price remains the same as INR 1,200, at that point in the cash market you don’t make any profit or lose anything, but make a profit of INR 50 in the futures market.

In all the scenarios, you still make a profit of INR 50, and that is how you make the most of the arbitrage funds.

What are the risks involved in Arbitrage Funds?

While there is much in favour of arbitrage funds, one must not forget that extreme market conditions can also cause disruptions. Such as the case of a sharp market correction in March 2020 that led to a decline in futures pricing, further halting the fresh inflow of two asset management companies, ICICI Prudential Mutual Fund and Tata Mutual Fund. Market leaders suggest investors to wait for a minimum three-month period to avoid huge risks.

Are Returns from Arbitrage Funds Worthwhile?

Arbitrage funds have recorded an average return of 5.68% during the last calendar year (2020), and 5.75% in the past three calendar years, which is equivalent to 5.66% and 6.48% in the liquid funds.

While there are considerable risks in the arbitrage funds category, given the market conditions, they are still a safer option for risk-averse investors if they reserve it for six to twelve months. Any longer than this period could become risky, as other hybrid categories come into the picture. Be that as it may, it is ideal to have an arbitrage fund manager to comprehend the subtleties of the risks and returns procedure of these funds.

What Does The Investment Cost You?

The Investment horizon of the arbitrage funds is a strong determinant, as there are several fees and charges attached to it, such as:

Expense ratios: Annual fees (1.09% for a regular plan and 0.41% for a direct plan) that includes fund manager’s fees and the management charges, charged at a percentage of the overall security assets.

Transaction costs: Unlike other funds, this is often consuming as there is frequent trading involved in the process.

Exit fees: In order to keep investors from exiting at the initial stage, arbitrage funds levy exit loads (0.25%) for a period of 30 days.

All these costs may increase your overall spend on the securities and may lower your take-home returns.

What Is The Role Of An Arbitrage Fund Manager?

The arbitrary fund manager’s job is to distinguish a chance in the spot and futures market. Likewise, the fund manager of the security guarantees that the resources are put into fixed-income securities to produce returns during low arbitrage openings. These funds perform well in a highly unstable market, given the manager has made the most of the mis-pricing opportunities.

Top-performing Arbitrage funds to invest

Here are 5 top-performing arbitrage funds to invest in:

UTI Arbitrage Fund

About Fund

The scheme aims to offer investors capital appreciation by investing in arbitrage opportunities across cash and derivative markets. It also explores arbitrage opportunities within the derivative segment by deploying surplus corpus in debt securities and money market instruments.

Inception DateJanuary 01, 2013
Benchmark NameNIFTY 50 Arbitrage Index
Fund ManagerAmit SharmaSharwan Kumar Goyal
Expense ratio0.35%
Fund typeOpen-ended
RiskLow

Historical Returns of the Fund (annualised)

1-Year2-Year3-Year5-Year10-Year
4.63%4.72%5.38%5.80%6.71%

ICICI Prudential Equity Arbitrage Fund

About Fund

The scheme aims to offer low volatility returns through an investment strategy focused on arbitrage and other derivative opportunities within the equity markets. It also invests in short-term debt instruments.

Inception DateJanuary 01, 2013
Benchmark NameNIFTY 50 Arbitrage Total Return Index
Fund ManagerNikhil KabraRohan MaruKayzad Eghlim
Expense ratio0.41%
Fund typeOpen-ended
RiskModerate

Historical Returns of the Fund (annualised)

1-Year2-Year3-Year5-Year10-Year
4.55%4.64%5.26%5.77%7.09%

Edelweiss Arbitrage Fund

About Fund

The scheme aims to offer income through an investment focus predominantly in arbitrage opportunities across cash and derivative segments of the equity markets. It also explores arbitrage opportunities in the derivative segment. Any balance is invested in debt and money market instruments.

Inception DateJune 27, 2014
Benchmark NameNIFTY 50 Arbitrage Total Return Index
Fund ManagerDhawal DalalBhavesh Jain
Expense ratio0.39%
Fund typeOpen-ended
RiskLow

Historical Returns of the Fund (annualised)

1-Year2-Year3-Year5-Year10-Year
4.77%4.93%5.59%6.04%6.73%

Kotak Equity funds Arbitrage Fund

About Fund

The scheme aims to offer investors income through different arbitrage opportunities that may emerge out of pricing differences between the spot & futures market. It may also deploy any surplus cash in fixed income instruments.

Inception DateJanuary 01, 2013
Benchmark NameNIFTY 50 Arbitrage Total Return Index
Fund ManagerHiten Shah
Expense ratio0.43%
Fund typeOpen-ended
RiskLow to moderate

Historical Returns of the Fund (annualised)

1-Year2-Year3-Year5-Year10-Year
4.71%4.75%5.37%5.85%7.11%

Should You Invest In Arbitrage Funds?

For those in the 30% tax slab, these funds often work better, as opposed to short-term debt funds because of their tax advantage. Hence, considering the post-tax benefits of these funds, they are better off than debt funds. Despite being in the equity funds category, the market doesn’t determine their returns, but the short-term interest rate in the economy does.

Final verdict: You can!

FAQs

What are arbitrage funds in India?

Arbitrage funds look for mis-pricing or price differentials of equity/stocks in the spot and futures market. These funds try to take advantage of the price differences between current and future securities to maximise returns. Fund managers of arbitrage funds also buy shares in the cash market and sell them in futures or derivatives markets for generating further returns.

Is it safe to invest in arbitrage funds?

Arbitrage funds generally have a low-to-moderate risk profile, similar to fixed income funds. These are ideal for investors who have a low-risk appetite and are looking for tax-adjusted returns. Investors who fall within the highest tax slab can consider investing in arbitrage funds in the short-term instead of debt funds.

Are arbitrage funds risk free?

These mostly fall under the low to medium risk category, so, while they cannot be called risk-free, they do carry lesser risk as compared to pure equity funds

Why are arbitrage mutual funds becoming attractive for investors?

Arbitrage funds are a great option as far as tax efficiency is concerned. Investors looking for lower capital gain tax rates can consider investing in these funds. Investors can make the most of superior tax advantage through arbitrage funds as compared to investing in liquid and short-term funds.

What is a hybrid arbitrage mutual fund?

Arbitrage funds are also called hybrid mutual funds, since they aim to generate returns through investment in debt as well as equity. The investment is mainly done to take advantage of different prices of various instruments.

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Akshatha Sajumon