Arbitrage Funds vs Arbitrage Trading: Differences, Types, Benefits & Taxation
Arbitrage trading is a strategy that earns profits from temporary price differences in the market. For investors who prefer a simpler approach, arbitrage funds use the same strategy through professional fund management. This guide explains how arbitrage trading and arbitrage funds work, their benefits, risks, taxation, and who should invest.
Key Highlights:
- Arbitrage trading generates profits by exploiting temporary price discrepancies in the same asset across markets.
- Arbitrage funds apply hedged methods to provide relatively low-risk, equity-based investment alternatives.
- Arbitrage returns depend on market spreads, liquidity, transaction costs, and timely execution of trades.
What is Arbitrage Trading?
Arbitrage is a trading strategy in which an investor purchases a commodity in a market where the price is lower and sells it in another market where the price is higher. The main intention of arbitrage trading is to benefit from temporary price inconsistencies without taking any market risk.
For instance, if the shares of Company ABC are being sold for ₹500 on the NSE and ₹505 on the BSE at the same time, the arbitrage trader will buy the shares for ₹500 and sell them immediately once they are priced at ₹505, making ₹5 per share.
What are Arbitrage Funds?
An Arbitrage Fund is an equity mutual fund that aims to generate returns by exploiting short-term price discrepancies in the stock market. It typically buys a stock in one market and sells it in another where the price is slightly higher, earning a small profit from the difference.
The fund manager continuously looks for these arbitrage opportunities between the cash market and the futures market. When such opportunities are not available, a portion of the fund may be invested in debt or money market instruments to maintain stability.
How Do Arbitrage Funds Work?
Arbitrage funds generate returns by exploiting temporary price differences between the cash market and the futures market.
Here's how the process works:
- Spot a Price Difference: The fund manager identifies a stock trading at different prices in the cash and futures markets.
- Buy in the Cash Market: The fund purchases the stock at the lower price in the cash market.
- Sell in the Futures Market: At the same time, the same stock is sold in the futures market at a higher price.
- Earn the Price Difference: When the trade is settled, the fund earns the difference between the buying and selling prices. This difference is called the arbitrage spread.
- Generate Returns for Investors: The fund repeats this strategy across different stocks whenever opportunities arise. The profits earned, after deducting expenses, contribute to the returns received by investors.
Example: Suppose ABC Ltd is trading at ₹1,000 in the cash market and ₹1,015 in the futures market.
- The fund buys the stock in the cash market for ₹1,000.
- At the same time, it sells the same stock in the futures market for ₹1,015.
- When the trade is completed, the fund earns a ₹15 profit per share (before costs and taxes).
This strategy helps arbitrage funds generate relatively stable returns by exploiting short-term price differences in the market.
How Does Arbitrage Trading Works?
Arbitrage trading exploits price discrepancies between assets in two different markets and aims to profit from the price differential. It consists of two steps that occur simultaneously.
- Spot the price difference: The trader finds the same asset having two different prices in two markets.
- Purchase the asset in the cheaper market: The asset is now bought in the market at a lower price.
- Sell the asset in the expensive market: At the same time, the asset is sold in the market at a higher price than when it was originally acquired.
- Make a profit from arbitrage trading: This profit derives from the difference between the purchase price and selling price of the asset after taking into consideration any floating costs such as carrying costs, taxes, etc.
Example: Suppose ABC Ltd. is trading at ₹1,000 on the NSE and ₹1,015 on the BSE at the same time.
- Buy 100 shares on the NSE at ₹1,000 each.
- Simultaneously sell 100 shares on the BSE at ₹1,015 each.
- Gross profit = (₹1,015 − ₹1,000) × 100 = ₹1,500 (before brokerage, taxes, and other charges).
By executing both trades simultaneously, the trader locks in the price difference rather than relying on future market movements.
Arbitrage Trading vs Arbitrage Funds
While both aim to benefit from price differences, they differ in terms of management, risk, taxation, and investor involvement.
| Factor | Arbitrage Trading | Arbitrage Funds |
| Managed By | Individual or professional traders | Professional fund managers |
| Investor Involvement | Requires active trading and market monitoring | No active involvement required |
| Investment Type | Direct trading strategy | Equity-oriented mutual fund |
| Risk Level | Moderate to High | Relatively Low |
| Returns | Depend on trading skills and market opportunities | Depend on available arbitrage opportunities |
| Taxation (India) | Taxed according to applicable trading tax rules | Taxed as an equity mutual fund. |
| Suitable For | Experienced Traders | Investors looking for a professionally managed investment |
| Ease of Investing | Requires trading knowledge and execution | Simple to invest through mutual fund platforms |
Types of Arbitrage Trading
Arbitrage trading can be carried out in different ways depending on the market and the type of price difference. Here are the most common types of arbitrage trading:
| Type | How It Works | Example |
| Pure (Spatial) Arbitrage | Buy an asset at a lower price in one market and sell it at a higher price in another market. | Buy gold at a lower price in one city and sell it in another city where the price is higher. |
| Cash and Carry Arbitrage | Buy an asset in the cash (spot) market and simultaneously sell it in the futures market when the futures price is higher. | Buy a stock at 1,000 in the cash market and sell its futures at 1,015, earning the 15-price difference. |
| Statistical Arbitrage | Use data analysis and algorithms to identify temporary price differences between related securities. | Two banking stocks usually move together. If one temporarily falls, traders profit when the prices realign. |
| Merger Arbitrage | Buy shares of a company being acquired before the merger is completed to benefit from the expected price increase. | A company offers to acquire another at 800 per share, while the target is trading at 780 per share. |
| Convertible Arbitrage | Buy convertible bonds and sell the company's shares to profit from the price difference between them. | An investor buys a convertible bond and shorts the company's stock to capture the price gap. |
| Forex Arbitrage | Profit from temporary exchange-rate differences across currency markets or currency pairs. | A trader earns from exchange-rate differences between the US Dollar, Euro, and Indian Rupee. |
Types of Arbitrage Funds
Arbitrage funds can be carried out in different ways depending on the stock market and the type of price difference. Here are the most common types of arbitrage funds:
| Type | How It Works | Example |
| Cash-Futures Arbitrage | Buys a stock in the cash market and simultaneously sells its futures contract when the futures price is higher, earning the price difference. | A stock trades at 1,000 in the cash market and 1,015 in the futures market. The fund profits from the 15 spreads. |
| Index Arbitrage | Takes advantage of price differences between a stock index and its corresponding index futures. | The Nifty 50 index is undervalued compared to Nifty futures, allowing the fund to profit from the gap. |
| Merger Arbitrage | Invests in companies involved in mergers or acquisitions to benefit from the difference between the current and expected acquisition price. | Company A announces it will acquire Company B at 500 per share, while Company B trades at 480 until the deal closes. |
| Statistical Arbitrage | Uses quantitative models to identify temporary pricing inefficiencies between related securities and executes trades automatically. | Two historically correlated banking stocks temporarily diverge in price, creating a short-term trading opportunity. |
| Cross-Market Arbitrage | Buys a security on one exchange where it is cheaper and sells it on another exchange where it is priced higher. | A stock trades at 750 on one exchange and 753 on another, allowing the fund to earn the 3 differences. |
| Currency Arbitrage | Profits from temporary exchange rate differences across different forex markets by buying and selling currencies simultaneously. | The USD/INR exchange rate differs slightly between two forex markets, enabling a small arbitrage gain. |
Benefits of Investing in Arbitrage Funds
Arbitrage funds can be a suitable option for investors looking for relatively stable returns with lower market risk.
- Lower Market Risk: Hedged trades help reduce the impact of market fluctuations.
- Equity Tax Benefits: Taxed as equity mutual funds, which can be more tax-efficient than some debt investments.
- Professional Management: Investment decisions are handled by experienced fund managers.
- Potentially Better Than Savings Options: May offer better post-tax returns than savings accounts or some short-term fixed-income options, depending on market conditions.
- High Liquidity: Units can generally be redeemed on any business day.
- Ideal for Short-Term Goals: Suitable for investors with a 3-12-month investment horizon.
Benefits of Arbitrage Trading
Arbitrage trading offers investors an opportunity to earn returns from temporary market price differences while reducing the impact of market volatility.
- Lower Market Risk: Simultaneous buy and sell transactions help minimise market risk.
- Stable Return Potential: Aims to generate relatively consistent returns from short-term price differences.
- Reduced Volatility: Hedged positions make arbitrage less sensitive to market fluctuations.
- High Liquidity: Most arbitrage opportunities involve highly liquid securities that are easy to trade.
- Professional Management: In arbitrage funds, experienced fund managers identify and execute arbitrage opportunities.
- Suitable for Short-Term Investing: A good option for investors seeking relatively low-risk, short-term opportunities.
Risks of Arbitrage Funds
Although arbitrage funds are relatively low risk, they are not completely risk-free.
- Limited Arbitrage Opportunities: Returns may vary when fewer price differences are available in the market.
- Market Risk: Sudden market movements can affect arbitrage opportunities and fund performance.
- Lower Return Potential: Returns are generally lower than those of diversified equity funds during strong bull markets.
- Interest Rate Risk: The debt and money market portion of the portfolio may be affected by changes in interest rates.
- Exit Load: Some arbitrage funds may charge an exit load if units are redeemed within a specified period.
- No Guaranteed Returns: As with all mutual funds, returns depend on market conditions and are not guaranteed.
Risks of Arbitrage Trading
Although arbitrage trading aims to reduce market risk, it is not entirely risk-free and can still be affected by various market and execution factors.
- Limited Return Potential: Profits are usually small because price differences are often short-lived.
- Execution Risk: Delays in placing buy and sell orders can reduce or eliminate expected gains.
- Liquidity Risk: Low trading volumes may make it difficult to execute trades at desired prices.
- Market Risk: Sudden market movements can affect arbitrage opportunities before trades are completed.
- Cost Impact: Brokerage charges, taxes, and other transaction costs can reduce overall returns.
- Regulatory Risk: Changes in market regulations or trading rules may impact arbitrage strategies.
Taxation of Arbitrage Funds
Since arbitrage funds invest at least 65% of their portfolio in equity and equity-related instruments, they are taxed as equity mutual funds under the current Indian tax rules in STCG and LTCG.
- Short-Term Capital Gains (STCG): Taxed at 20% if units are sold within 12 months.
- Long-Term Capital Gains (LTCG): Taxed at 12.5% on gains exceeding ₹1.25 lakh in a financial year if units are held for more than 12 months.
Taxation of Arbitrage Trading
The tax on arbitrage trading depends on the holding period of the investment and the applicable capital gains tax rules.
- Short-Term Capital Gains (STCG): Taxed at 20% if shares are sold within 12 months.
- Long-Term Capital Gains (LTCG): Taxed at 12.5% on gains exceeding ₹1.25 lakh in a financial year if shares are held for more than 12 months.
Things to Consider Before Investing in Arbitrage Funds
Before investing in an arbitrage fund, evaluate these factors to ensure it aligns with your financial goals and investment needs.
- Investment Horizon: Arbitrage funds are suitable for short-term investments, typically 3 to 12 months.
- Expense Ratio: Choose a fund with a lower expense ratio, as lower costs can improve your overall returns.
- Assets Under Management (AUM): A larger AUM may indicate greater investor confidence and better liquidity.
- Exit Load: Check whether the fund charges an exit load for early redemption.
- Tax Efficiency: Understand the tax treatment of arbitrage funds and how it fits your overall tax planning.
- Liquidity Needs: Ensure the fund meets your cash flow requirements, especially if you may need to withdraw funds in the short term.
- Financial Goals: Invest only if the fund aligns with your investment objective, risk tolerance, and time horizon.
Things to Consider Before Arbitrage Trading
Understanding a few key factors before starting arbitrage trading can help you manage risks and make better investment decisions.
- Consider market liquidity: check trading volume in the securities to ensure they can be traded.
- Compare transaction costs: before engaging in trading, make sure to check commissions, taxes, and other fees.
- Take action without delays: when there are arbitrage opportunities, it is necessary to execute the transactions quickly.
- Realise the risks: execution delays, price changes, and liquidity risk.
- Use a trustworthy broker: one that can execute trades quickly.
- Learn about taxes: be aware of tax treatment before trading starts.
Conclusion
Arbitrage trading is a strategy that aims to generate returns from temporary price differences in the market while reducing directional market risk. Whether you trade directly or invest through arbitrage funds, understanding the risks, costs, taxation, and market conditions is essential before investing.
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