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Arbitrage Fund is a type of Mutual Fund which takes advantage of the differences in price of securities in the cash and derivatives market to generate a return.

This article covers the following:

  1. How do Arbitrage Funds work?
  2. Who should invest in Arbitrage Funds?
  3. Things to consider as an Investor
  4. How to Invest in Arbitrage Funds?
  5. Top 5 Arbitrage Funds in India

 

1. How do Arbitrage Funds work?

Arbitrage Funds work on the mispricing of equity shares in the spot and futures market. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market. The difference in the cost price and selling price is the return you earn. Let’s understand this with the help of an example.

Suppose the equity share of a company ABC trades in the cash market at Rs. 1220 and in the future market at Rs.1235. The fund manager buys ABC share from cash market at Rs 1220 and shorts a futures contract to sell the shares at Rs 1235. 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 transaction costs. 

Conversely, if the fund manager feels the price to fall in future, he shorts equity shares in the cash market and enters into a long contract in the futures market. He will short sell the shares in the cash market at Rs 1235. At the expiry date, he buys shares in the futures market at Rs. 1220 to cover up his position and earns a profit of Rs. 15. In yet another scenario, the fund manager may buy 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 make a risk-free return.

 

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2. Who should Invest in Arbitrage Funds?

Arbitrage funds make money from low-risk buy-and-sell opportunities available in the cash and futures market. Their risk profile is similar to that of a debt fund. In fact, many arbitrage funds use Crisil BSE 0.23% Liquid Fund Index as their benchmark. These funds are tailor-made for investors who are looking for an exposure to the equity markets but are wary of risks associated with them. Arbitrage funds become a safe option for the risk-averse individuals to park their surplus money when there is a persistent fluctuation in the market.

These funds leverage the market inefficiencies to generate profits for the investors in the intermediate horizon. In addition to taking positions in the equity markets, the fund manager allocates the remaining assets in the fixed-income generating instruments. While doing this, he ensures that the investment is made only in high-credit quality debt securities like zero-coupon bonds, debentures, and term deposits. This helps to keep the fund returns in line with expectations during the period of inadequate arbitrage opportunities.

 

Arbitrage funds
 
 

3. Things to consider as an Investor

 

a. Risk

 
As trades are carried out on the stock exchange, there’s no counterparty risk involved in these funds. Even though the fund manager is buying and selling shares in cash and futures market, there is no risk exposure to equities as is the case with other diversified equity mutual funds. Though the ride looks smooth, do not get too comfortable with these funds. As more people start trading into arbitrage funds, there will be not many arbitrage opportunities available. The spread between cash and future market prices will erode, leaving little for the arbitrage focused investors.

b. Return

Arbitrage Funds may be a good opportunity to make reasonable returns for those who can 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 have been found to give returns in the range of 7%-8% over a period of 5-10 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, arbitrage funds may be your thing. However, you need to keep one thing in mind that there are no guaranteed returns in arbitrage funds.

c. Cost

Cost becomes an important consideration while evaluating arbitrage funds. These funds charge an annual fee called expense ratio which is expressed as a percentage of the fund’s assets. It includes fund manager’s fee and fund management charges.  Due to frequent trading, arbitrage funds would incur huge transaction costs and has 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 increase in the expense ratio of the fund. A high expense ratio puts a downward pressure on your take-home returns.

d. Investment Horizon

Arbitrage funds may be suitable for investors having a short to medium term horizon of 3 to 5 years. As these funds charge exit loads, you may consider them only when you are ready to stay invested for a period of at least 3-6 months. At the same time, you need to 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 absence of volatility, liquid funds may give better returns than arbitrage funds over the same investment horizon. Hence, you need to 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 your thing. Instead of a regular savings bank account, you may use these funds to park excess funds in order to create an emergency fund and earn higher returns on them. In case you were already invested in riskier havens equity funds, then you may begin a systematic transfer plan (STP) from the equity funds to a less risky haven like arbitrage funds as you approach completion of the financial goal. This would reduce your portfolio’s overall risk profile but at the same time reduce the returns also. You cannot expect to earn double-digit returns in arbitrage funds.

f. Tax on Gains

These funds are treated as equity funds for the purpose of taxation. If you stay invested in them for a period of up to 1 year, you make short-term capital gains (STCG) which are taxable. STCG are taxed at the rate of 15%. If you stay invested in them for a period of more than 1 year, the gains will be treated as long-term capital gains (LTCG). LTCG in excess of Rs.1lac is taxed at the rate of 10% without the benefit of indexation. Instead of sticking to pure debt funds, these are funds are suitable for conservative investors who are in higher tax brackets to earn tax-efficient returns.
 

4. How to Invest in Arbitrage Funds?

 
Investing in Debt Funds is made paperless and hassle-free at ClearTax. Using the following steps, you can start your investment journey:

Step 1: Sign in at cleartax.in
Step 2: Enter your personal details regarding the amount of investment and period of investment
Step 3: Get your e-KYC done in less than 5 minutes
Step 4: Invest in your favorite arbitrage fund from amongst the hand-picked mutual funds

5. Top 5 Arbitrage Funds in India

While selecting a fund, you need to analyze the fund from different angles. There are various quantitative and qualitative parameters which can be used to arrive at the best arbitrage funds as per your requirements. Additionally, you need to keep your financial goals, risk appetite and investment horizon in mind.

The following table represents the top 5 arbitrage funds in India based on the past 1 year returns. Investors may choose the funds based on a different investment horizon like 5 years or 10 years returns. You may include other criteria like financial ratios as well.
 

Fund Name
L&T Arbitrage Opportunities Fund Regular Growth
Reliance Arbitrage Fund - Growth
Kotak Equity Arbitrage Fund Growth
SBI Arbitrage Opportunities Fund Regular Growth
UTI Arbitrage Fund Regular Plan Growth

 
*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.
 

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