Arbitrage Funds - Price differences can be good

Differences can be good and can lead to opportunity. Imagine a scenario where you buy a pencil from the wholesale market for Rs. 5. The next day you go to the neighbouring retail market and discover that the same pencil costs Rs. 7 in this market. Observing the difference in the price of the pencil, you see this as an opportunity to make money. You decide to buy the pencil in the wholesale market for Rs. 5 and sell it in the neighbouring retail market for Rs. 7, thereby making a profit of Rs. 2 per pencil. This is exactly how an arbitrage fund works.

The workings of an arbitrage fund

When it comes to mutual fund investments, most of you must be aware of equity funds, debt funds, and even hybrid funds like a balanced advantage fund. However, there is another type of fund under hybrid funds called Arbitrage funds. These funds take advantage of the difference in pricing of the same equity shares in 2 or more markets. In case of equities, there are 2 main types of markets, i.e., the spot market and the futures market. The spot market deals with the current price of the stocks while the futures market deals with the future price of the stocks. Arbitrage funds identify the gap between the prices of a stock in the spot market and the futures market and attempt to give you risk-free returns by simultaneously buying and selling the same security in the two markets to lock-in the price differential.

Let us understand the working of an arbitrage fund with an example.

Assume that the equity shares of ABC Ltd trade at Rs. 1000 in the cash market. At the same time, these shares are trading at Rs. 1020 in the futures market. In order to take advantage of this price differential, the fund manager buys the shares in the cash market at Rs. 1000 and uses a futures derivatives contract to sell an equivalent number of shares at Rs. 1020 in the futures market. At the end of the month, when the futures contract expires, the price of the futures contract becomes the same as the price of the stock in the cash market.  This way, the fund manager is able to generate a risk-free profit of Rs. 20 per share subject to transaction costs.

Similarly, fund managers can also take advantage of the price differential on two different stock exchanges. For example, assume that the shares of Energy Ltd are trading at Rs. 100 on the National Stock Exchange (NSE) and at Rs. 110 on the Bombay Stock Exchange (BSE). Similar to our pencil example, the fund manager can buy the shares on NSE and sell them on BSE, thereby locking in a profit of Rs. 10 per share.

Are arbitrage funds right for you?

Investing in an arbitrage fund would be a wise decision if you fall into any one or more of the following categories.

1. The aim of arbitrage funds is to take advantage of market mispricing and generate profits for the investors over a medium time horizon. Thus, it will work best for you if you are willing to stay invested for at least 1.5 to 3 years.

2. In the case of an arbitrage fund, volatility is your friend rather than your enemy. This is because price differentials occur in volatile markets. Hence, these funds are well suited for investors who do not have the potential to take the high risk of pure equity funds.

3. For the purpose of taxation, arbitrage funds are treated as equity funds, i.e., profits made within one year of investment are treated as short-term capital gains and taxed at 15% while profits made after one year of investment are treated as long-term capital gains. This means that profits up to Rs. 1 lakh are exempt from tax and profits over Rs. 1 lakh are taxed at 10%. If tax efficiency is important to you then arbitrage funds can be considered as an investment.

Arbitrage funds are considered safer than several categories of mutual funds. Further, they also make a compelling investment for those people who want exposure to equities but are afraid of market volatility. These two factors make arbitrage a great investment option for most investors. 

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