Exploring the market-neutral approach of arbitrage funds

core strategy of arbitrage funds is to buy assets in one market where the price is low and simultaneously sell them in another market where the price is higher, thereby capitalising on the price difference. The price difference of a stock on different exchanges and the price difference of a stock between cash and futures markets are the two main arbitrage opportunities used by fund managers to generate profits.

However, if the market has a bull run or a bear run, the returns can be affected. This is why a market-neutral approach is desired.

• Table of contents

1. Understanding market neutral approach of arbitrage mutual funds
2. Explore arbitrage fund opportunities in market volatility
3. Factors to consider when exploring a market-neutral approach of arbitrage fund investment

Understanding market neutral approach of arbitrage mutual funds

Arbitrage funds are categorised under hybrid funds. The market-neutral approach of arbitrage mutual funds is used to earn potential returns while attempting to minimise sensitivity to broader market movements. Fund managers try to achieve a balance so that gains in some investments offset losses in others, resulting in a relatively stable return potential regardless of overall market trends. This market-neutral approach of arbitrage fund investment (of taking offsetting positions) potentially helps them take advantage of relative price movements while minimising exposure to overall market direction.

Explore arbitrage fund opportunities in market volatility

Periods of volatility can create better arbitrage opportunities because of increased price differentials and inefficiencies across markets. Here are a few arbitrage strategies:

Volatility arbitrage: Volatility arbitrage means trading options, futures, or other derivatives to potentially capitalise on discrepancies between implied volatility and the actual price movements of the underlying assets.

Price discrepancies between stock exchanges: In times of market volatility, fund managers seek to capitalise on price divergences between related securities or assets. They simultaneously buy undervalued assets and sell overvalued assets to generate return potential when prices revert to their fair values.

Merger and acquisition arbitrage: It involves trading securities of companies involved in mergers, acquisitions, or corporate restructuring activities. Fund managers simultaneously buy shares of the target company and short-sell shares of the acquirer (or vice versa) to potentially capture the spread between the current and the expected price.

Factors to consider when exploring a market-neutral approach of arbitrage fund investment

Here are some factors you must consider when exploring the market-neutral approach of arbitrage mutual funds:

Types of strategies employed: Understand the specific market-neutral strategy employed by the fund, including convertible arbitrage, merger arbitrage, volatility arbitrage and so on.

Role of the fund in your portfolio: Assess why you want an arbitrage fund in your investment portfolio. Such a fund does not typically yield returns as high as a well-performing equity fund in the long run but can be used as a relatively low risk short-term investment tool. Determine the appropriate allocation size based on your investment strategy, risk appetite, and portfolio construction principles.

Liquidity and redemption terms: Consider the liquidity profile of the arbitrage fund, including the liquidity of underlying assets, redemption terms, and investor exit options.

Transparency and reporting: Seek transparency and disclosure from the arbitrage fund regarding portfolio holdings, trading activities, performance attribution, and risk exposures. Evaluate the quality and frequency of reporting, investor communications, and access to information to make informed investment decisions and monitor portfolio performance effectively.

Fees and expenses: Understand the fee structure of the arbitrage fund, including management fees, performance fees, and other expenses. Evaluate the impact of fees on net returns and consider whether the potential benefits of the market-neutral approach justify the cost incurred.

Conclusion

Arbitrage funds try to exploit price differentials, inefficiencies, or mispricing across different markets. The market-neutral approach of arbitrage mutual funds offers investors potential benefits including a relatively lower level of risk, a potential of earning reasonable returns irrespective of market movements, and more efficient taxation. However, investors must consider several factors to assess the suitability, risks, and potential rewards when exploring the market-neutral approach of arbitrage fund investment.

FAQs

What is the market-neutral approach of arbitrage fund investment?

The market-neutral approach of arbitrage mutual funds is an investment strategy designed to generate return potential that is independent of overall market movements. They aim to achieve positive returns regardless of whether the broader market is rising, falling, or remaining relatively stable.

How can liquidity risks impact market-neutral strategies?

Low liquidity may delay or prevent the timely execution of arbitrage opportunities, impacting the arbitrage fund's ability to capture the price differences between markets and generate return potential. It can be challenging to execute trades at desired prices, leading to higher transaction costs, change in bid-ask spreads and potential price slippage.

What are the potential benefits of the market-neutral approach of arbitrage mutual funds?

The market-neutral approach can help arbitrage fund investors manage risk and generate reasonable returns across different market environments.

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