1. What is an Arbitrage Fund?
Arbitrage funds work on the mispricing of equity shares in the spot and futures market. Mostly, it takes advantage of the price differences between current and future securities to generate maximum returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets. The difference in the cost price and the selling price is the return you earn.
2. How Does Arbitrage Funds Work?
Suppose the equity share of a company ABC trades in the cash market at Rs 1,220 and in the future market at Rs 1,235. The fund manager buys ABC shares from the cash market at Rs 1,220 and sorts a futures contract to sell the shares at Rs 1,235. Towards the end of the month when the prices coincide, the fund manager will sell the shares in the futures market and generate a risk-free profit of Rs 15 per share less the transaction costs.
Conversely, if the fund manager feels the price to fall in future, he enters into a long contract in the futures market. He will short-sell the shares in the cash market at Rs 1,235. At expiry, he buys shares in the futures market at Rs 1,220 to cover up his position and earns a profit of Rs 15. In yet another scenario, the fund manager may purchase an equity share for Rs.100 in National Stock Exchange (NSE) and sell the same at Rs.120 in the Bombay Stock Exchange (BSE) to generate a risk-free return.
3. Role of Arbitrage Fund Manager
These funds take advantage of the markets to generate profits for the investors over a medium time horizon. This will handle the volatility risk that may arise due to equity exposure. Also, the fund manager allocates the remaining assets in the fixed-income generating instruments. The fund manager will ensure that the investments are made only in high-credit quality debt securities such as zero-coupon bonds, debentures, and term deposits. This helps in keeping the fund returns in line with the expectations during the period of inadequate arbitrage opportunities.
4. Who should invest in Arbitrage Funds?
Arbitrage funds make profits from low-risk buy-and-sell opportunities in the cash and futures market. Their risk level is comparable with that of a pure debt fund. Several arbitrage funds follow Crisil BSE 0.23% Liquid Fund Index as their benchmark.
These funds are apt for those investors who are looking to have equity exposure but are worried about the risk associated with the same. Arbitrage funds are a safe option for risk-averse individuals to safely park their surplus funds when there is a persistent fluctuation in the market.
5. Things to consider as an Investor
a. Risk factor
As trades happen on the stock exchange, there’s no counterparty risk involved in these funds. Even when the fund manager is buying and selling shares in the cash and futures market, there is no exposure to equities as is the case with other diversified equity mutual funds.
Though the investment journey seems to be smooth, do not get too comfortable with these funds. As more people start trading into arbitrage funds, there will not be many arbitrage opportunities available. The spread between cash and futures market prices will erode, leaving little for the arbitrage focused investors. In this case, you may have to invest in other kinds of debt funds to earn better returns.
Arbitrage Funds are an excellent option to earn reasonable profits for those who understand it and then make the most of it. The fund manager tries to generate an alpha using price differentials in markets.
Historically, arbitrage funds are known to offer returns in the range of 7% to 8% over five years to ten years. If you are looking to earn moderate returns via a portfolio which has a perfect blend of debt and equity in a volatile market, then arbitrage funds are apt for you. However, it is essential to note that there are no guaranteed returns in arbitrage funds.
c. Cost of investment
Cost becomes an important consideration when evaluating arbitrage funds. These funds charge an annual fee called the expense ratio, a percentage of the fund’s overall assets. It includes the fund manager’s fee and fund management charges.
Due to frequent trading, arbitrage funds would incur substantial transaction costs and a high turnover ratio. Additionally, the fund may levy exit loads for a period of 30 to 60 days to discourage investors from exiting early. All these costs may lead to an increase in the expense ratio of the fund. A high expense ratio puts downward pressure on your take-home returns.
d. Investment horizon
Arbitrage funds could be suitable for investors having a short to a medium-term horizon of 3 years to 5 years. As these funds charge exit loads, you may consider them only when you are ready to stay invested for at least 3-6 months.
Please understand that fund returns are highly dependent on the existence of high volatility. So, choosing a lump sum investment would make sense over systematic investment plans (SIPs). In the absence of volatility, liquid funds may provide better returns than arbitrage funds over the same investment horizon. Hence, it would be best if you keep the overall market scenario in mind while choosing arbitrage funds.
e. Financial goals
If you have short to medium-term financial goals, then arbitrage funds are apt. Instead of a regular savings bank account, you may use these funds to park excess funds to create an emergency fund and earn higher returns on them. In case you have already invested in riskier options such as equity funds, you may begin a systematic transfer plan (STP) from the equity funds to a less risky haven like arbitrage funds as you approach achieving your financial goals. This would not only reduce your portfolio’s overall risk but also reduce the returns at the same time. You cannot expect to earn double-digit returns in arbitrage funds.
f. Tax on gains
These funds are treated as equity funds for taxation. If you stay invested for less than one year, then you make short-term capital gains (STCG) which are taxable. STCG is taxed at a rate of 15%. If you stay invested for more than a year, then gains will be considered as long-term capital gains (LTCG). LTCG over Rs.1 lakh a year is taxed at the rate of 10% without the benefit of indexation. Instead of sticking to pure debt funds, these funds are suitable for conservative investors who are in higher tax brackets to earn tax-efficient returns.
6. How to Invest in Arbitrage Funds?
Investing in debt funds is made paperless and hassle-free at ClearTax. You can start your investment journey through the following steps:
– Sign in at cleartax.in and choose a plan
– Enter all the requested details
– Invest in your preferred arbitrage fund amongst the hand-picked mutual funds
7. Top 5 Arbitrage Funds in India
When selecting a fund, it would be best if you analyse it from various angles. Several quantitative and qualitative parameters can help you figure out the best arbitrage. Additionally, it would help if you keep your financial goals, risk appetite and investment horizon in mind.
The following table shows the top five arbitrage funds in India based on the past three year returns. So, investors may choose the funds based on a different investment horizon like five years or ten years returns. You may include other criteria such as financial ratios as well.
3 Years Returns
*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.