What are Arbitrage Funds – Complete Details
Arbitrage Fund is a type of mutual Fund.This article will explain the complete details about Arbitrage Funds.It will explain the meaning , benefits , drawbacks and the way Arbitrage funds work.
What are Arbitrage Funds?
– Arbitrage Funds refer to a type of Mutual Fund, which has arbitrage as its main objective.
– These Funds deal in the cash market (stock market) and derivative market (futures, options etc) simultaneously.However ,these funds may also trade over different stock exchanges to exploit profit making opportunity.
– These Funds will buy the stocks of a company on a stock exchange and at the same time may take the short position on the futures in the derivatives market.
– The difference or arbitrage gain is meager or very thinner as compared to other similar transactions.Hence , these funds will have to trade the huge volume of such arbitrage transactions.
How do these work?
Let us work through examples for understanding the way in which the Arbitrage Funds work.
– EXAMPLE 1
Suppose there is an Arbitrarge Fund ‘”AF” .It purchases shares of company “A” @ Rs 100.At the same time , futures of one month are trading @ Rs 150.
In this case , Spot price = Rs 100 and future price = Rs 150
The futures are trading at higher price than cash market security . Hence it would imply that the markets are bullish for the coming month.Bullish trends always lead to further increase in price.Hence , The Fund “AF” takes short position on these futures.
The difference between spot price and future price is arbitrage gain.
Arbitrage Gain = 150-100 = Rs 50
Generally the futures market does not deal in single security.Futures contracts are normally in the size of 100 shares per contract.Hence “AF” will have to buy minimum 100 shares and simultaneously sell off future contract.
Suppose , “AF” sells 2 futures contracts and buys 200 shares , thereby making an arbitrage gain of
(150-100)x 200 = Rs 10000
– EXAMPLE 2
Suppose Fund “AF” purchases shares of the company “A” which are currently trading @ Rs. 30 on National Stock Exchange )NSE.The same stock is trading @ Rs 40 on BSE (Bombay Stock Exchange).
So the Fund “AF” decides to short sell the 100 shares purchased on NSE on BSE index.In such case
Arbitrage Gain = 40-30 = Rs 10
Fund “AF” is able to earn arbitrage gain of (Rs 10 x 100 )Rs 1000.
Benefits of Arbitrage Funds
– Low on risk
When you invest in the stock market or futures market for a long term , it increases the risk of losing money.This is because most of the times , the market is unpredictable.In the long run , it is quite risky to get the money tied up.These Funds short sell whenever there is an arbitrage opportunity.
Arbitrage Funds usually balance by investing partially in equity and partially in debt.These funds tend to invest more in debt when there are lesser arbitrage opportunities in stock markets. Hence ,the shorter time period of investing and debt exposure , make it less risky.
– Move with market trends
Arbitrage Funds generally ride on market volatility trends.This is because arbitrage funds exploit the market volatility trends.The distinctive market bullish (buying spree) or bearish (selling spree) trends create an opportunity for arbitrage.
– Lower risk along with higher rewards
Arbitrage Funds invest in arbitrage opportunities.Though market volatility poses risk of losing money , it also gives rise to differentials in pricing.This creates gaps between pricing due to volatile market trends.This benefits the investors with balanced rewards with lower risk.
Drawbacks of Arbitrage Funds
– Static market leads to dull returns
Arbitrage Funds exploit the gaps between pricing in various markets and various stock exchanges.This outlines the main requirement of market volatility to create arbitrage opportunity.Hence static markets are the biggest hurdle for profit making.In such cases , devoted equity funds outperform as compared to such arbitrage funds.
– Higher expenses or cost for arbitraging
As mentioned earlier , the arbitrage gain per unit is much smaller.Hence , the arbitrage fund needs to carry out huge volumes of trades for earning high magnitude of gains.This leads to high expense ratio as compared to other mutual fund types.
– Unpredictable returns
Markets are always unpredictable in terms of returns.So arbitrage funds alone should not be the portfolio.Each investor shall analyse the risk appetite and investment goals and shall invest accordingly.
Don’t forget your tax quotient
Where the Arbitrage Funds have held in equity more than 65% , such funds are treated at par with regular Equity Linked Mutual Funds.Hence they will receive following tax treatment
– LTCG (Long Term Capital Gain) – Exempt
– STCG (Short Term Capital Gains) – Taxed at concessional rate of 15%
– Dividend – Exempt
CONCLUSION
Due to stable returns and less risky model , Arbitrage Funds have strength of becoming market leader.These funds are lucrative to the cautious Investors.Also these funds are suitable for high tax bracket persons , who wish to receive benefits from equity market but wish to stay away from volatility.
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