Can arbitrage funds be a suitable option for risk-averse investors?

Arbitrage funds are often considered relatively low risk investments due to their market neutral strategy. But are they truly risk-free and suitable for conservative investors focusing on risk mitigation? This article analyses the various risks and performance aspects of arbitrage funds in detail.

• Table of contents

1. How does arbitrage fund work?
2. Relative stability of returns
3. Potential risks
4. Performance in trending markets
5. Are arbitrage fund investments stable?
6. Things to consider when choosing arbitrage funds

How does arbitrage fund work?

Arbitrage funds which come under the category of hybrid mutual funds make use of temporary differences between the prices of identical securities in the cash and derivatives markets. When the fund manager spots stocks quoted at marginally different levels on these exchanges, they buy in one market and simultaneously sell in the other to lock in the profits. Repeating this strategy over short holding periods aims to generate potentially steady returns.

Relative stability of returns

By not taking directional market views, arbitrage funds deliver relatively stable NAVs than regular equity schemes. However, past performance may or may not be sustained in future). Short holding periods of 1-30 days also reduce exposure to volatility. As long as pricing anomalies exist, these funds can provide relatively stable returns.

Potential risks

Liquidity issues during market crashes can disrupt hedging trades. High trading costs can also impact profits. Mispricing owing to lack of price convergence is another risk. In addition, sector-specific events can distort typical cash-futures relationships as well.

Performance in trending markets

While less impacted than equity funds, arbitrage returns may be moderate during extended bull or bear phases. Pricing anomalies become scarce as futures premiums inflate/deflate disproportionately. Sluggish markets shrink trading opportunities.

Are arbitrage fund investments stable?

Yes, arbitrage fund investments can be considered relatively stable compared to other debt and equity funds. Due to their market neutral strategy, arbitrage funds aim to deliver relatively steady returns regardless of overall market movements. By exploiting short-term price differences between the cash and futures market for the same securities, arbitrage funds can potentially generate stable returns. As long as these temporary anomalies exist, the fund is able to lock in risk-free gains through hedged positions.

While no investment is completely risk-free, the low-beta approach of arbitrage funds makes them a comparatively stable option. Proper fund selection and experienced management can further enhance return predictability.

For investors seeking relatively steady returns with lower risk than debt or equity, arbitrage funds offer risk mitigation as a priority over high appreciation. This makes them suitable for many conservative savings goals.

Things to consider when choosing arbitrage funds

Track record - Check how the fund has performed over different market conditions and its ability to deliver steady returns.

Expense ratio - Lower costs leave more room for returns. Watch out for high total expense ratios.

Portfolio holdings - Understand the types of stocks held and ensure there is adequate diversification.

Conclusion

For conservative goals, arbitrage funds offer relatively lower risk than pure debt or equity alternatives due to their market neutral strategies. However, one must be aware of inherent risks as well as opportunity costs to assess their actual suitability to one’s portfolio. Fund selection is also important to benefit from a proven arbitrage process. One of the arbitrage funds worth considering is the Bajaj Finserv Arbitrage Fund. For a detailed information, click here.

FAQs:

Are arbitrage fund investments risk free?

No, arbitrage fund investments are not completely risk free. While they carry lower risk compared to pure equity funds, there are some inherent risks such as liquidity issues during market downturns, high trading costs impacting profits, mispricing due to lack of price convergence between cash and futures markets, and sector specific events distorting typical relationships

How do arbitrage funds perform in trending markets?

Arbitrage fund returns may moderate during periods when markets are in extended bull or bear phases. In trending markets, pricing anomalies that arbitrage funds exploit become less prevalent as futures premiums inflate or deflate disproportionately. This shrinks the trading opportunities available for arbitrage fund managers.

What factors impact arbitrage fund returns?

Arbitrage fund returns can be impacted by several factors - liquidity issues during periods of market volatility can disrupt hedging trades carried out by funds. High transaction costs involved in the arbitrage strategy also affect the profits generated. Mispricing of securities due to a lack of convergence between cash and futures prices is another risk that may moderate returns. Sector-specific events can also distort the typical relationships between spot and derivatives markets that arbitrage funds rely on.

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.