What makes arbitrage mutual funds an attractive investment option?

Investors are always in search of investment avenues that offer favourable risk-reward ratios. Those who wish to take a relatively lower risk but get reasonable returns can opt for arbitrage mutual funds. Arbitrage funds invest at least 65% of their assets in equity and equity-related instruments but are relatively low-risk and may generate potentially better returns than debt funds.

Let’s look at what arbitrage funds are and how they work.

• Table of contents

1. What are arbitrage mutual funds?
2. How arbitrage funds work?
3. Why are arbitrage mutual funds becoming popular?
4. Who should invest in arbitrage funds?
5. 3 things to consider before investing in arbitrage funds

What are arbitrage mutual funds?

Arbitrage funds are equity-oriented hybrid mutual funds that capitalise on price discrepancies to generate profits by buying and selling securities in different market segments. Basically, the fund managers buy the security in the market where the price is lower and sell in the market where the price is higher.

Now that you what arbitrage funds are, let’s understand how an arbitrage fund investment works.

How arbitrage funds work?

Arbitrage mutual funds thrive in volatile market conditions. Let’s understand it with an example. Assume that the equity of Company A is Rs. 100 per share on the cash market and Rs. 105 on the futures market. The fund manager buys 10,000 shares and sells a futures contract. The risk-free gain would be Rs. 50,000 (Rs. 5 x 10,000) when the futures contract expires.

In case the price of the share dips and the share trades at Rs. 90 in the cash market and Rs. 85 in the futures market, the fund would still make a profit. Here’s how – the fund is losing Rs. 10 (Rs. 100 – Rs. 90) per share in the cash market but gaining Rs. 20 (Rs. 105 – Rs. 85) in the futures market. Thus, the net gain is Rs. 10 per share (Rs. 20 – Rs. 10) for a total profit of Rs. 1 lakh (Rs. 10 x 10,000). (For illustrative purpose only)

This shows how arbitrage mutual funds can perform well in bullish as well as bearish markets.

Why are arbitrage mutual funds becoming popular?

The surge in the popularity of arbitrage funds can be attributed to various factors such as:

Better risk-reward ratio: While being equity-oriented funds, arbitrage funds are still considered low-risk investments as compared to pure equity products. Thus, they have a better risk-reward ratio than pure debt and equity funds.

Suitability for volatile conditions: Ever since the COVID-19 pandemic hit the world, markets across the globe have seen many bullish and bearish runs. These volatile conditions suit arbitrage funds where the focus is on exploiting temporary market inefficiencies. Instead of trying to predict the market direction, arbitrage fund managers try to spot price differentials across markets.

Tax-efficiency: Since they invest more than 65% of their assets in equity and equity-related instruments, arbitrage funds are taxed like equity funds. If the investor holds the investment for over 12 months, Long-term Capital Gains (LTCG) tax is applied to the capital gains from the investment. There is no tax payable on capital gains up to Rs. 1 lakh. Long-term Capital Gains (LTCG) of more than Rs. 1 lakh are taxed at 10% (Plus applicable cess and surcharge)

Ease of investment: Arbitrage funds are accessible through online portals and Asset Management Companies (AMCs) in India. This means that you can easily make an arbitrage fund investment once you have discussed it with your financial advisor.

Who should invest in arbitrage funds?

You should consider investing in arbitrage mutual funds if:

• You have a low-risk appetite.
• You have an investment horizon of at least 6 to 12 months.
• You want to tap into the investment opportunity in volatile market conditions.
• You want to build a contingency fund.

3 things to consider before investing in arbitrage funds

Risk Level: Arbitrage funds carry low risk, but they are not entirely risk-free. Also, these funds may not generate good returns under stable market conditions.

Investment Horizon: If you invest in arbitrage mutual funds for less than 12 months, you will be taxed under the Short-term Capital Gains category which is levied at the tax slab rate of the individual.

In conclusion, arbitrage funds are suitable for conservative investors who have an investment horizon of at least 6 to 12 months. They carry a lower level of risk as compared to equity funds and usually offer relatively reasonable returns than debt funds like liquid funds. If you want to tap into the investment opportunities arising during volatile market conditions, then arbitrage mutual funds can be a suitable investment option for you.

FAQs:

What is an arbitrage mutual fund ?

An arbitrage fund aims to profit from price differentials in securities between the cash and derivative markets.

Why makes arbitrage funds a preferred option?

They offer relatively stable returns with lower volatility compared to equity funds, making them a suitable option during uncertain market conditions.

What should investors consider before investing in arbitrage funds?

Liquidity, tax efficiency, and the fund's track record are crucial factors to evaluate when considering arbitrage funds for your portfolio.

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 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.