What are arbitrage funds and are they viable during market volatility?

Investments in arbitrage funds have seen an upward trend in recent years. More and more investors are getting drawn towards these funds, especially during periods of market volatility. In this article, we will explore what arbitrage funds are, how they work, why they have gained popularity, and ultimately, whether they are a viable investment option amidst market turbulence.

• Table of contents:

1. What are arbitrage funds?
2. What is a good time to invest in arbitrage funds?
3. Why arbitrage funds became popular?
4. How arbitrage funds work?
5. What is the risk in an arbitrage fund?

What are arbitrage funds?

Imagine being able to benefit from the price difference in various financial instruments or securities. That's precisely the premise behind arbitrage funds – a type of hybrid mutual fund that invests primarily in equities and equity-derivatives simultaneously. Arbitrage funds aim to generate returns by exploiting price differentials between the cash and derivative markets or by capitalizing on price disparities in related assets. By employing a relatively low-risk strategy, arbitrage funds strive to deliver potentially consistent, moderate returns, irrespective of the market's overall direction.

What is a good time to invest in arbitrage funds?

Undoubtedly, arbitrage funds can be an attractive option during market volatility. When uncertainty prevails, and traditional investment avenues appear risky, arbitrage funds can act as a relatively stable option for your capital. Arbitrage funds work best when the markets are volatile. These funds capitalise on market inefficiencies and generate opportunistic profits. Since investment opportunities are few, most investors consider the lumpsum route to earn relatively better returns.

Why arbitrage funds became popular?

The popularity of arbitrage funds can be attributed to several factors that make them stand out in the investment landscape.

Relatively steady returns: Firstly, their ability to generate relatively steady returns, regardless of the market's overall movement, appeals to many investors seeking some stability from equity investing.

Level of comfort: Additionally, their relatively low-risk nature provides a certain level of comfort during periods of heightened market volatility.

Hedged positions: Unlike other investment options that can be adversely affected by sharp market downturns, arbitrage funds tend to maintain their value due to their hedged positions.

How arbitrage funds work?

The below example is for illustrative purpose only:
Imagine you decide to invest in the equity shares of a company called XYZ. In the regular cash market, XYZ shares are priced at Rs. 1,000, while in the future market, they are trading at Rs. 1,100 each. The plan is that by the end of the month, if the stock reaches the future market price, the fund manager will sell the share to make a profit of Rs. 100 per share.
Additionally, the fund manager could also choose to purchase shares of XYZ in the National Stock Exchange (NSE) and then sell them at a higher price in the Bombay Stock Exchange (BSE) to take advantage of price discrepancy and generate a seemingly risk-free return.
However, it is essential to recognize that such investment strategies are not without risks. If the markets experience minimal or no volatility, these schemes may fail to generate the expected profits.

What is the risk in an arbitrage fund?

While arbitrage mutual funds are generally considered low risk, they are not entirely devoid of potential drawbacks. One key risk factor is the market risk that arises during periods of extreme market volatility.

Market risk: Certain events such as sudden regulatory changes or unexpected macroeconomic shifts can create unforeseen price disparities that may affect the fund's returns. Additionally, since arbitrage opportunities are time-sensitive, any delays in executing trades could lead to reduced profitability or missed opportunities.

Liquidity risk: Investors should also be aware of liquidity risk. While arbitrage funds are relatively liquid compared to traditional closed-end funds, they may still face redemption pressures during market downturns, leading to potential liquidity issues. This could force the fund manager to sell positions at unfavorable prices, impacting overall returns.

Management risk: Lastly, like any investment, arbitrage funds are subject to management risk. The fund's performance is highly dependent on the expertise and decision-making of its fund managers.
In conclusion, arbitrage funds in volatile times present an enticing option for investors looking to navigate through market volatility while seeking relatively steady returns. Their unique strategy of capitalizing on price imbalances provides a sense of relative stability on returns during uncertain times. However, it is essential to remember that no investment is entirely risk-free. While arbitrage mutual funds aim to reduce risk, they are still subject to market fluctuations and various other risks associated with their specific strategies.

FAQs:

How does a fund for arbitrage operate?

An arbitrage fund buys shares in the cash market and concurrently sells them in the futures or derivatives market. The return you get is the difference between the cost price and the selling price.

What are the advantages of arbitrage funds?

Arbitrage funds offer relatively low-risk returns, suitable for short-to-medium term investment goals with less stock market risk. They are comparable to pure debt funds and can provide reasonable returns on surplus cash.

Are there any risks or disadvantages of arbitrage funds?

Arbitrage funds face risks and disadvantages, including interest rate risk, credit risk, market risk, expense ratios, lack of arbitrage opportunities, and average returns. Investors should monitor expense ratios and arbitrage opportunities available in the market to mitigate potential risks.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.