Arbitrage funds are hybrid mutual funds that generate returns by leveraging price discrepancies between different markets. These funds operate by capitalizing on the price differences of the same asset in various markets, mainly focusing on the cash and futures markets. The strategy involves buying an asset in one market and selling it in another to exploit the price gap.

How arbitrage funds work

• Exploiting price disparities: Arbitrage funds seek to benefit from pricing inefficiencies between markets. Price differences can arise due to factors such as supply-demand imbalances, market inefficiencies, or variations in trading volumes. By identifying and acting on these discrepancies, arbitrage funds aim to secure profits.
• Cash market investments: In the cash market, arbitrage funds purchase stocks or other securities at current market prices. These assets are chosen based on their liquidity and their arbitrage opportunities. This market serves as the foundation for the arbitrage strategy.
• Future market transactions: These funds simultaneously sell equivalent positions in the futures market. Futures contracts are agreements to buy or sell an asset at a set price on a specified future date. By locking in a future selling price through these contracts, the fund secures its position and mitigates potential risks associated with price fluctuations in the cash market.

Key features of Arbitrage Funds

• Potentially stable returns: Arbitrage funds are designed to generate returns regardless of the overall market movement. This characteristic provides a sense of security and appeals to investors who seek stability and security in their investments, especially during volatile market conditions.
• Low-risk nature: Arbitrage funds generally exhibit relatively low risk due to their strategy of exploiting price differences and maintaining hedged positions. This quality provides a level of comfort to investors during heightened market volatility.
• Hedged positions: Unlike other investment options that may suffer from significant market downturns, arbitrage funds tend to preserve their value because of their hedged positions. A hedged position is a strategy where the fund takes offsetting positions in different markets to reduce the risk of significant losses. This strategy helps mitigate adverse effects from sharp market movements.

Considerations before Investing in Arbitrage Funds

• Investment objectives: Before investing in arbitrage funds, it is crucial to clarify your investment objectives. Whether your goal is capital preservation, moderate growth, or tax efficiency, understanding your objectives will help you select the right fund.
• Risk tolerance: While arbitrage funds are typically considered low risk, they are not completely risk-free. Assess your risk tolerance to ensure it aligns with the fund’s risk profile. This understanding will help you make an informed investment decision.
• Tax implications: Understand the tax implications of investing in arbitrage funds. The tax treatment of gains can vary based on the holding period. Long-term capital gains above Rs. 1 lakh are taxed at 10%, while short-term capital gains are taxed at 15%. Consulting a tax advisor can provide clarity on how these implications might affect your investments.
• Fund selection: Choose a fund with a solid track record, experienced fund managers, and a low expense ratio. Research various arbitrage funds to find one that aligns with your investment objectives and provides the best value.

Benefits of Investing in Arbitrage Funds

• Lower risk profile: Compared to traditional equity funds, arbitrage funds offer a lower risk profile. They focus on capturing short-term price discrepancies rather than broad market movements, which may result in less exposure to market volatility.
• Steady returns: Arbitrage funds aim to offer consistent returns by taking advantage of price differences between markets. This feature is particularly beneficial in volatile markets, making these funds a suitable option for investors seeking stability in their investment portfolios.
• Tax advantages: Arbitrage funds offer tax benefits similar to equity funds. Long-term capital gains over Rs. 1 lakh are taxed at 10%, while short-term capital gains are taxed at 15%. These tax advantages can improve your overall investment returns.

Conclusion

Arbitrage Funds offer a unique investment approach within the hybrid mutual funds category. These funds aim to provide potentially stable returns with a relatively low-risk profile by leveraging price discrepancies between the cash and futures markets. Investors looking at arbitrage funds should assess their investment goals, risk tolerance, and potential tax impacts. Selecting a well-managed fund with a consistent track record can further enhance the potential benefits of this investment strategy. With their focus on exploiting market inefficiencies and maintaining hedged positions, arbitrage funds may be valuable to a diversified investment portfolio.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.