Arbitrage funds have gained significant popularity among investors. But still, a good section of individuals are unaware of its capabilities.
Many investment experts believe that arbitrage is the way to generate wealth. Arbitrage works to correct the mispricing of equity shares in the spot and future markets. Arbitrage funds buy and sell assets focusing on profiting from price differences between markets. This article will discuss arbitrage funds and their various features and aspects that you should know.
What is Arbitrage?
Arbitrage means buying and selling an asset in two different markets and profiting from the difference in prices between the markets. Arbitrage funds are based on the principle that the cash and futures markets are two markets for arbitrage.
This may seem complicated to a layman. But arbitrage is very simple once you understand the difference between cash and futures markets.
- Cash Market: Transactions take place in real time. An example of a spot market is the secondary market for equity shares on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE), where your account is debited immediately after the trade is executed.
- Future market: In the future market, you can buy rights to buy or sell equity shares at a predetermined price on a future date. The price of an asset in the futures market may be higher or lower than the spot market depending on investor sentiment. The difference between the spot and futures markets that arbitrage funds try to capitalize on.
What are Arbitrage Funds?
Arbitrage funds are mutual funds that work on the principle of arbitrage. The objective of these funds is to generate profits for investors by transacting in derivatives and cash markets. For example, the fund manager buys an asset on the cash market at the spot price and sells it at a higher price in the futures market, thereby profiting from the price difference.
Arbitrage fund risk
It is interesting to note that arbitrage funds are comparatively less risky. When market volatility increases, arbitrage funds perform well. Since funds buy and sell assets simultaneously, they avoid the risks associated with long-term investments. If you invest in arbitrage funds, volatility is the least of your worries. As long as the market continues to move in either direction, the fund manager will find opportunities to capitalize.
Arbitrage fund returns
So, what is the return expectation from an arbitrage fund? Returns from the fund depend on the number of arbitrage opportunities available in the market. Therefore, when markets are volatile and arbitrage options are plentiful, arbitrage funds perform better.
Things to remember while investing in arbitrage funds
Role of fund manager
The fund manager is responsible for effectively identifying and taking advantage of arbitrage opportunities to continue generating returns for the fund.
Risk
Since these funds trade on stock exchanges, there is no counterparty risk involved. Arbitrage funds do not attract risks like other diversified equity mutual funds. However, as more investors try to capitalize on arbitrage opportunities, the market begins to decline, resulting in fewer opportunities.
Return
The fund manager buys and sells assets simultaneously to generate income. But these opportunities are few, and hence the returns are average. If you invest for 5-8 years, you can expect around 8% returns.
Cost of investment
These funds charge an annual expense ratio, which includes the fund manager's fees and fund management charges. The expense ratio is a fixed percentage of the total funds invested.
Tax
Arbitrage funds are treated as equity funds, and taxes are levied on them as per capital gains tax rules. If you invest for less than a year, a short-term capital gains tax of 15 per cent will be levied on your capital gains.
Disclaimer: Mutual fund investments are subject to market risks, read all scheme-related documents carefully.
