What Are “Arbitrage Funds”?

Arbitrage funds are those kinds of mutual funds, whose modus operandi is to take advantage of the price variation between assets, which in theory should have the same price. These kinds of mutual funds allow the investor to earn gains from unstable financial markets. Arbitrage funds do not have a high degree of risk associated with them but also the resultant amount of gains from these kinds of mutual funds cannot be accurately predicted.

The taxation method which is applied to “equity Funds” can also be applied to the “Arbitrage funds” to calculate the precise amount of tax. But the investors should be aware of the pertaining expense ratios. Among the several variants of “arbitrage”, an important one occurs between cash and futures markets. An investor makes an investment in a mutual fund by hoping to sell it later but at a high price so that he can earn a good amount of profits. But in the case of “Arbitrage funds”, a completely different scenario can be seen because this kind of fund makes purchases of stocks in the cash market and at the same time, it vends that interest in the future market.

“Futures contracts” are homogeneous to “Stock prices”. So if the arbitrage funds want to make a significant amount of gains, then they must perform a large number of tradings every year. The price of a stock in the financial market at the current time is known “spot price”. But in the case of the “Futures market”, things work differently. The valuation of “Future contracts” is not built on the present price of the concerned stock rather these “Future contracts” foretell the stock price for the nearby future. When the trading is being done in the futures market, the ownership of the shares of a stock does not gets transferred immediately. Instead, the transfer of shares is done on the maturity date of the contract at the accorded price.

The purpose of ‘Arbitrage Funds” is to benefit from these different kinds of prices.  These kinds of mutual funds purchase stock in the cash market and concomitantly venders it’s contract on the futures market but only if the financial market is “Bullish” on the underlying stock. But in case of the financial market being “Bearish”, futures contracts are bought at a low price by the arbitrage funds, and simultaneously the shares are sold on the cash market for a higher price. But arbitrage funds does not function only in cash markets and futures markets, they earn gains by trading different stocks on different stock exchanges also.

Features:

  • “Taxability”

As told above the taxation method which is applied to “Arbitrage Funds” is the same method that is applied to calculate the tax on “Equity funds” because the investment by arbitrage funds is done mostly in equities. Those investors who fall within the tax bracket of 20% to 30%, are strongly advised to make an investment in “Arbitrage funds” as it will work as a secured place for their money. If an investor has held an arbitrage fund for more than one year, then he is not required to pay any tax on the returns earned from the said funds (Also known as “Long term Capital Gains”). But if an investor has held the said funds for less than one year, he is required to pay a 15% tax on returns from these kinds of mutual funds (Also known as Short Term Capital Gains”).  But there is a bright side to the whole taxation aspect as there is no implication of “Dividend Distribution Tax” on “Arbitrage funds”. These kinds of mutual funds are not meant for investors who want are looking at a short-term investment horizon. And since “arbitrage funds” are based on equity, the amount of risk involved is not that much high in comparison to other kinds of financial securities, which are also equity-based.

  • A low percentage of Risk

 Since the financial instruments involved in arbitrage funds are bought and sold concomitantly, the risk percentage gets reduced by a large amount. And these kinds of mutual funds always make sure to invest a part of their capital amount into debt securities, which are very stable. In the case where there are inadequate profitable arbitrage trades, then there is a higher investment in financial securities which are debt-based. There are times in the ‘Financial market” when there is no occurrence of any volatilities. And in such times there is no change in the prices of most individual stocks. So in the case of “Arbitrage Funds,” an individual must understand that risk and patience are two of the most important factors. Without a high percentage of risk, a significant amount of gains cannot be earned. These kinds of funds are highly recommended to those investors who have a low-risk tolerance.

 Disadvantages Of “Arbitrage funds”

  • “Unpredictable rewards”

These kinds of mutual funds cannot be considered as highly reliable because they do not allow an investor to earn significant gains during a period of stability in the financial market. And if there is not a significant amount of profitable arbitrage trades available in the financial market, these kinds of a mutual fund, tend to become “Bonds funds” but only for a temporary period of time. And if arbitrage funds have spent more than a predetermined amount of time as bond funds, then the profitability levels tarts to deplete.

  • “High Expense ratios”

Since arbitrage funds require a significant number of trades to generate a good amount of profits, this causes the expense ratios to reach a high level. And whenever there is a prolonged period of instability in the financial markets, then arbitrage funds tend to make the most of it. But investors should be careful about making an investment in these kinds of mutual funds due to their low level of reliability.

An “Arbitrage Fund Manager’s role” :

Since “Arbitrage funds” tend to make profits from an unstable financial market, so the fund manager makes sure that the remaining assets are invested in those kinds of financial securities that have a fixed rate of return. Also the “Arbitrage Fund manager” will make sure the investment amount is only moved towards those kinds of debt securities that have a high credit quality. Some examples of the former statement are “zero-coupon bonds, debentures, and term deposits”. This whole process allows an investor to keep the gains from arbitrage funds in a straight alignment with the expectations occurring during a period of insufficient arbitrage trade opportunities.

Those types of investors who want to get familiar with “equity” but are afraid of the risks attached to it are advised to make an investment in “Arbitrage funds”. These kinds of mutual funds can be considered as a safer option for investors who have a low-risk tolerance.

 The Top 10 “Arbitrage Funds of 2020” are

Name Of  FundsAUM (In Crores)3 Year Returns
  Nippon India Arbitrage Fund10,5286.94%  
  Edelweiss Arbitrage Fund3,8706.86%  
  IDFC Arbitrage Fund11,9446.80%  
  BNP Paribas Arbitrage Fund649  6.75%  
  Axis Arbitrage Fund2,9086.72%  
  Kotak Equity Arbitrage Fund17,486  6.71%  
  L & T Arbitrage Fund799  6.71%  
  ABSL Arbitrage Fund  5,4936.70%  
  ICICI Prudential Equity Arbitrage Fund14,024  6.65%  
  Indiabulls Arbitrage Fund36  6.47%  

Related Links

Thinking Beyond The Traditional Investment Options In 2020

How to Calculate Your Tax Liability in Debt Mutual Funds with Indexation?

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