How Does Arbitrage Funds Work & its Benefits?
The word arbitrary generally refers to random, whim, or taking a chance.
Similarly, an arbitrage fund takes advantage of changing prices of
securities to buy and sell in seemingly random, but calculative moves.
What is an Arbitrage Fund?
Arbitrage funds work on the mispricing
of equity shares in the spot and futures market. Mostly, it takes
advantage of the price differences between current and future securities
to generate maximum returns. The fund manager simultaneously buys
shares in the cash market and sells it in futures or derivatives
markets. The difference in the cost price and the selling price is the
return you earn.
How Does Arbitrage Funds Work?
Suppose the equity share of a company ABC trades in the cash market at Rs 1,220 and in the future market at Rs 1,235. The fund manager
buys ABC shares from the cash market at Rs 1,220 and sorts a futures
contract to sell the shares at Rs 1,235. 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
the transaction costs.
Conversely, if the fund manager feels the price to fall in future, he
enters into a long contract in the futures market. He will short-sell
the shares in the cash market at Rs 1,235. At expiry, he buys shares in
the futures market at Rs 1,220 to cover up his position and earns a
profit of Rs 15. In yet another scenario, the fund manager may purchase
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 generate a
risk-free return.
Role of Arbitrage Fund Manager
These funds take advantage of the markets to generate profits for
the investors over a medium time horizon. This will handle the
volatility risk that may arise due to equity exposure. Also, the fund
manager allocates the remaining assets in the fixed-income generating instruments.
The fund manager will ensure that the investments are made only in
high-credit quality debt securities such as zero-coupon bonds,
debentures, and term deposits. This helps in keeping the fund returns in
line with the expectations during the period of inadequate arbitrage
opportunities.
Who should invest in Arbitrage Funds?
Arbitrage funds make profits from low-risk buy-and-sell
opportunities in the cash and futures market. Their risk level is
comparable with that of a pure debt fund. Several arbitrage funds
follow Crisil BSE 0.23% Liquid Fund Index as their benchmark.
These funds are apt for those investors who are looking to have equity
exposure but are worried about the risk associated with the same.
Arbitrage funds are a safe option for risk-averse individuals to
safely park their surplus funds when there is a persistent fluctuation
in the market.
Things to consider as an Investor
Risk factor
As trades happen on the stock exchange, there’s no counterparty risk
involved in these funds. Even when the fund manager is buying and
selling shares in the cash and futures market, there is no exposure to
equities as is the case with other diversified equity mutual funds. Though the investment journey seems to be smooth, do not get too comfortable with these funds.
As more people start trading into arbitrage funds, there will not be
many arbitrage opportunities available. The spread between cash and
futures market prices will erode, leaving little for the arbitrage
focused investors. In this case, you may have to invest in other kinds
of debt funds to earn better returns.
Return
Arbitrage Funds are an excellent option to earn reasonable profits for
those who 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 are known to offer returns in the range of
7% to 8% over five years to ten 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, then
arbitrage funds are apt for you. However, it is essential to note that
there are no guaranteed returns in arbitrage funds.
Cost of investment
Cost becomes an important consideration when evaluating arbitrage funds. These funds charge an annual fee called the expense ratio,
a percentage of the fund’s overall assets. It includes the fund
manager’s fee and fund management charges. Due to frequent trading,
arbitrage funds would incur substantial transaction costs and 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 an increase in the expense ratio of the fund. A high expense
ratio puts downward pressure on your take-home returns.
Investment horizon
Arbitrage funds could be suitable for investors having a short to a
medium-term horizon of 3 years to 5 years. As these funds charge exit
loads, you may consider them only when you are ready to stay invested
for at least 3-6 months. Please 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
the absence of volatility, liquid funds may provide better returns
than arbitrage funds over the same investment horizon. Hence, it would
be best if you keep the overall market scenario in mind while choosing
arbitrage funds.
Financial goals
If you have short to medium-term financial goals, then arbitrage
funds are apt. Instead of a regular savings bank account, you may use
these funds to park excess funds to create an emergency fund and earn
higher returns on them.
In case you have already invested in riskier options such as equity funds, you may begin a systematic transfer plan
(STP) from the equity funds to a less risky haven like arbitrage funds
as you approach achieving your financial goals. This would not only
reduce your portfolio’s overall risk but also reduce the returns at the
same time. You cannot expect to earn double-digit returns in arbitrage
funds.
Tax on gains
These funds are treated as equity funds
for taxation. If you stay invested for less than one year, then you
make short-term capital gains (STCG) which are taxable. STCG is taxed at
a rate of 15%. If you stay invested for more than a year, then gains
will be considered as long-term capital gains (LTCG).
LTCG over Rs.1 lakh a year is taxed at the rate of 10% without the
benefit of indexation. Instead of sticking to pure debt funds, these
funds are suitable for conservative investors who are in higher tax
brackets to earn tax-efficient returns.
For more information on this, visit TAXAJ
Posted by Aashima
Team TaxaJ
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