Arbitrage funds are low-risk mutual fund schemes that aim to exploit pricing mismatches in various segments of equity markets to generate risk-free profits for investors.
While historical data shows that, arbitrage opportunities exist in Indian equity markets most of the time, volatility in the equity market increases the pricing mismatches between different market segments and hence arbitrage profits are higher in volatile markets. This is one investment product that helps investors profit from economic uncertainties and volatility in the equity markets.
Why Arbitrage Mutual Funds?
Short-term Advantage
Investors can park their funds which they plan to use for short-term requirements in arbitrage mutual funds, instead of keeping them in savings accounts or even money market mutual funds like liquid funds or ultra-short-term funds. Data shows that, in volatile market conditions, arbitrage funds outperform liquid funds. Arbitrage funds have low risk and are highly liquid, which means that you can redeem your fund at any time to use it for your emergency needs. Please note that arbitrage funds can charge exit loads for redemptions within a week or a month (read the scheme information document of the fund you are investing in carefully before investing).
Tax Advantage
The tax advantage of arbitrage mutual funds makes it a winner in volatile markets. For taxation purposes arbitrage mutual funds are treated as equity mutual funds. Short term capital gains (holding less than a year) are taxed at 15%, while long term capital gains (holding more than a year) are tax-free. Dividends declared by arbitrage mutual funds are also tax-free. Investors have different strategies to deal with uncertainty, but arbitrage mutual funds can always help with cash flows through higher returns in times of emergency or a sudden need for funds.
How does Arbitrage Mutual Funds work?
Arbitrage funds take into account the different protection rates for profit generation in a different market. Cash (stock) markets and futures (derivatives) markets are the two markets wherein arbitration funds deal primarily.
Unlike the stock market, instead of taking into account the present value of securities, the futures market works on the expected price of the securities at a future time. At present, the price of a security on the stock exchange is known as the spot price. The future date of the deal referred to in the futures contract is known as the date of maturity.
Unlike a cash deal, securities bought in the future market will be shipped to the investor before the expiry date of the contract. The trade will take place at maturity at the pre-decided price set out in the futures contract.
Arbitrage Funds generate dividends from the stock price gap between the stock market and the futures market. If the demand is strong, a given number of stocks are bought from the stock market and sold on the derivatives market simultaneously. The arbitration fund will buy the futures contract at a lower price and sell the same amount of shares on the stock exchange at the current spot price if the market is predicted to see a decline.
Example of Arbitrage Mutual Fund
Suppose the share price of a company is Rs 100 and the futures price (in the F&O market) is Rs 110. On the expiry of the futures contract, the spot price (share price in the cash market) and futures price will converge. If you buy 1000 shares of the company in the cash market and sell 1000 futures, you will lock in a gross profit of Rs 10,000 irrespective of whether the price rises or falls.
People Often Ask
- What are the best Arbitrage Funds to invest in?
- What is an arbitrage mutual fund?
- Are arbitrage funds safe?
- Which is a better liquid fund or arbitrage fund?
Some of the best arbitrage funds to invest in are:
Arbitrage funds are low-risk mutual fund schemes that aim to exploit pricing mismatches in various segments of equity markets to generate risk-free profits for investors.
Yes, arbitrage funds are safe and have 2 major benefits i.e Short-term advantage and tax advantages. However, Arbitrage funds are subject to market risks.
It depends on the fact that if you are looking for low-risk investment or tax saving and comparatively higher risk investment. Liquid Funds are suitable for low-risk investors and arbitrage funds are suitable for tax saving investors.
Conclusion
Arbitrage funds do better during market fluctuations relative to other stock-oriented hybrid funds, since it creates a gap between the spot price and the equity price of the futures contract. However, if the market is less volatile, mutual funds with low-risk debt can outperform arbitration funds.