Equity markets are known to be volatile, and this inherent volatility keeps most investors from investing. However, experienced investors are aware that this same volatility can be leveraged and used to create investment opportunities. Arbitrage funds focus on leveraging market volatility, and have been gaining a lot of traction in the last few years.

This article will focus on everything you need to know about arbitrage funds.

What is an Arbitrage fund?

The term arbitrage means simultaneous buying and selling of securities or commodities or currencies from diverse markets to take advantage of the difference in price points.

Arbitrage funds are equity funds that invest in stocks as well as equity derivative instruments of matching securities and volume to exploit the price differential between the two market segments.

How do Arbitrage funds work?

Fund managers evaluate the price difference in the securities of the spot and the futures market. If the price is higher in the spot market, the fund manager buys the security in the futures market. At the same time, the fund manager will sell the same quantity of the security in the spot market. The difference between the price of the security in both the markets is the fund manager’s gain, excluding other costs.

Let’s understand this with the help of an example^*.

Assume that the equity shares of company XYZ trade at Rs. 1,100 in the cash (spot) market and at Rs. 1,125 in the futures market. The fund manager buys the shares from the cash market at Rs. 1,100 and sorts a futures contract to sell the shares at Rs. 1,125. Towards the end of the month, the fund manager will sell the shares in the futures market and generate a profit of Rs. 25 per share, excluding the transaction costs.  

Tax Benefits on Arbitrage Funds

Arbitrage mutual funds are taxed similar to equity funds. The following table explains the tax on arbitrage funds:

Benefits of Investing in Arbitrage Funds

Following are some of the advantages of investing in arbitrage mutual funds:

1. Low risk: One of the primary benefits of investing in arbitrage mutual funds is that these are low-risk securities. As securities are bought and sold simultaneously, the risk associated with long-term investments is not applicable.
2. Suitable for the volatile market: Arbitrage funds are one of the few types of low-risk securities that flourish well in a highly volatile market. Since individual stock prices see significant fluctuations in a volatile market, arbitrage mutual funds use it to their advantage through the instantaneous buying and selling in different markets.
3. Taxed similar to equity funds Arbitrage funds are taxed similar to equity funds as equities constitute an average of 65% in the fund. If an investor holds these funds for a period of one year or more, then the gains received are taxed at capital gains’ rates. Thus, arbitrage funds offer a tax advantage over other funds.

Who Should Invest in Arbitrage Funds?

Arbitrage funds in India appeal to those investors who desire a profit from the volatile markets while not subjecting their investments to high risk. The risk level of arbitrage mutual funds is comparable to that of pure debt mutual funds. Investors with short- to medium-term goals can consider investing in arbitrage mutual funds.

Risk Factor of Investing in Arbitrage Funds

Arbitrage mutual funds are not very profitable in stable market conditions as the fund majorly invests in debt instruments, such as bonds, which offer low yield. This results in a drastic difference in arbitrage funds’ returns as compared to actively managed equity mutual funds.

Things to Consider While Investing In Arbitrage Mutual Funds

Any investment requires abundant research and valuation of factors such as history of returns accrued, risk involved, cost of investment, etc. Following are some of the factors that you should consider before investing in arbitrage funds:

1. Financial goals It is important to ensure that your financial goals are aligned with the fund's objective. Arbitrage mutual funds are ideal for short- to medium-term goals. Instead of parking your excess funds in a regular savings account, an investor can consider investing in arbitrage mutual funds to earn higher returns.
2. Cost involved: Various costs are involved with mutual fund investments, such as entry load, exit load, expense ratio, etc. Investors must review these expenses before investing in arbitrage funds. Due to frequent trading, these funds could incur high transaction costs and a substantial turnover ratio.
3. Fund performance: It’s important to measure the fund’s performance in both bearish and bullish markets as it can help the investor select a reliable fund. Arbitrage mutual funds are known for their mediocre reliability. However, these mutual funds are one of the rare kinds of low-risk investments that can perform well in a volatile market.
4. Return on investment: These funds are ideal earning reasonable profits for those investors who understand their inner workings. An investor looking to earn moderate returns from their mutual fund investments that have a perfect ratio of debt and equity funds might consider investing in arbitrage mutual funds.
5. Tax on arbitrage mutual funds: Arbitrage funds are taxed similar to equity funds. The gains earned on investments held for less than 12 months are known as short-term capital gains (STCG), which are taxed at 15%. On the other hand, gains earned on investments held for more than 12 months are considered as long-term capital gains (LTCG). LTCG in excess of Rs. 1 lac are taxed at 10% without the benefit of indexation.

How to Invest in Arbitrage funds

If you are wondering how to buy arbitrage funds, just follow these easy steps:

1. Sign up and create a mutual fund account with an AMC (Asset Management Company)
2. Submit your KYC documents in case you have not done so already
3. Input the necessary details, as required
4. Identify the right funds and invest in mutual funds based on your personal and financial goals, risk tolerance, and investment horizon
5. Select the apt open-ended arbitrage fund that suits your portfolio and transfer the required amount
6. As an investor, you can also give your bank standing instructions in case you want to invest via SIP  

To sum up, arbitrage funds are one of the best investment options for risk-averse investors. During high and persistent volatility in the market, arbitrage mutual funds can offer investors a reasonable avenue to park their hard-earned money. These mutual funds capitalise on the market inefficiencies and help generate profits for the investors. Happy Investing! 

*Example is only for illustrative purposes only and should not be relied upon as an accurate indication.