Arbitrage Funds: The Right way of Leveraging Market Volatility

In the words of William Feather,

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.”

This clearly reinstates the fact that the stock market always has buyers and sellers wanting to trade on a particular stock. The basis for this trade is mostly the price. Price being an essential weapon, can be manipulated and taken advantage of.

In today’s article, we will look into the nuances of an innovative financial product that can help medium-scale investors take advantage of price differentials.

What are Arbitrage Funds?

An Arbitrage Fund is a type of mutual fund that helps an investor benefit from the price difference in the cash and futures market. It is an open-ended hybrid mutual fund with equity and debt components but is majorly dominated by equity. According to SEBI, a fund must have a minimum proportion of 65% in equity (stocks) and equity-related instruments (like futures and options), to be called an arbitrage fund.

How do Arbitrage Funds work?

Oxford defines arbitrage as the process of buying from one place at a lower price and selling it in another at a higher price. This is exactly how an arbitrage fund works. The process is similar to the arbitrage practices adopted in the foreign exchange market and the futures market. The only distinction is that because this is a hybrid fund, there is also a small debt component.

For example, if a stock is trading at Rs.1,000 in the spot market and Rs. 1,500 in the derivative market. An arbitrageur would purchase the stock from the spot market and sell it on the derivative market. He, in this case, realizes a profit of Rs. 500 per share.

In a regular arbitrage, the investor himself keeps a constant check on the prices in various markets and decides to buy and sell to earn profits. But in an arbitrage mutual fund, this is not the case.

The responsibility of this tedious job is passed on to the fund manager. If you have chosen the right arbitrage fund, you can sit back and relax. The fund manager, by using his expertise, would decide the right time and quantity to purchase and sell. Their main objective is to make profits for you. No wonder why the cost (expense ratio) of these funds is high!

Benefits of Arbitrage Funds

Let’s now look into some of the benefits that these funds provide.

1. Low risk

The execution of a buy-and-sell in a short period of time ensures that long-term players are not really exposed to high risk. Plus, the risk is additionally mitigated by investing in debt securities. The proportion invested in the debt varies with the varying rates of equity derivatives. This helps the arbitrage funds to remain stable and eventually control the quantum of risk.

2. Taxation benefits

Accruing to its high equity content, the tax treatment of this fund is similar to that of an equity fund. According to Indian taxation, if this fund is held for a period of less than a year, the tax on short-term capital gain applies, which is 15%; otherwise, long-term gains would be taxed at 10% (if above Rs 1 Lakh). Whereas in the case of debt funds, short-term capital gains are taxed at the individual’s highest applicable tax slab rate, while long-term gains are taxed at 20%. 
As arbitrage funds are classified as equity funds, they have a tax advantage. They would benefit from investing in debt and not having to bear the tax liability of a debt fund.

3. Best option in a volatile market

An arbitrage fund is an amazing combination of a low-risk financial product that performs well in an unstable market condition. Unstable markets simply mean that the share prices are witnessing high fluctuations. Therefore, the more the market journeys towards instability, the more profits these funds realize.

Drawbacks of Arbitrage Funds

Like any other investment product, this fund is not free from cons. Let’s understand a few of them.

1. Unpredictability 

Arbitrage funds perform well in unstable markets, which means that their performance is weak or unpredictable in stable market conditions. If the proportion of debt components is increased to combat this, it will result in lower returns.

2. High costs

The frequency of the buying and selling increases the cost incurred. Constant watch on the markets and predictability is necessary, which requires sound knowledge and expertise. No doubt, it comes at a high price! For adding to the perspective, the turnover ratio (amount of the mutual fund portfolio that has changed in a year) of the Edelweiss Arbitrage fund is 357%, and to match it, the expense ratio is 1.39%. So, now you know.

Should you invest?

As we already established, for an investor with a low-risk appetite wanting to exploit the volatile markets, an arbitrage fund is one of the few options available. However, there are certainly other factors you should evaluate before parking your savings into this fund. 

First and foremost, your financial objective. If you are looking for a long-term investment product, an arbitrage fund might not be a good option. It is perfect for the short to medium term.

Having said that, this fund can be a good alternative to a debt fund. But again, the cost is a big deciding factor!

Top-performing Arbitrage Funds in India

Currently, some of the top-performing arbitrage funds in terms of CRISIL rating and the yield provided are: 

• L&T Arbitrage Opportunities fund

• Tata Arbitrage fund

• UTI Arbitrage fund

• Kotak Equity Arbitrage fund

• Edelweiss Arbitrage fund

The Bottom Line

Stock market investing is definitely a risky business. But does that mean they can be completely avoided? No. If one is looking to increase their passive income sources and also combat the effects of inflation, stock markets and mutual funds are the solutions.

On average, bank deposits fetch interest of 3%-6%, and retail inflation currently stands at around 5.59%. It is clearly evident that bank deposits aren't the solution anymore. Low-risk products like arbitrage funds are available in the market for risk-averse investors, which serves the purpose without hurting much.

Anyway, you must consider your investment objectives and only then decide if it’s time to “make hay while the sun shines!”

Invest wisely.