Understanding Arbitrage Funds

by otopenews

Before jumping directly to understand what Arbitrage Funds are, let us first understand the basic meaning of “Arbitrage”.

In simple words, arbitrage means buying in one market and selling in another market. For example, I buy a T-shirt in one market for say Rs. 700 and I sell that T-Shirt in another market where the demand is more at a price of Rs. 850. I have instantly made a profit of Rs.150.

So what have I done? In order to make profit, I buy in the market where the price is low and sell in the market where the price is high. This situation of having different prices in different markets gives me an opportunity to make profit. This is called Arbitrage.

Now let’s see how it works in the finance world. In this context, the markets are nothing but the stock exchanges. We have two prominent markets i.e. Bombay Stock Exchange and National Stock Exchange. Ofcourse, there are other stock exchanges as well but for simplicity sake, we are considering these two. If you notice there is always a slight difference in the prices of stocks listed on these stock exchanges. For instance, Stock A has a price of Rs.50 in BSE and Rs. 50.40 in NSE. As an investor, I can buy this stock in BSE at Rs. 50 and sell it in NSE at Rs. 50.40 and book a profit of Rs. 0.40.

You may say it’s just a small amount. Why will we invest?

This is just one stock and usually these transactions happen in huge volumes. So the profit amount is sizable.

I hope you have now understood what is an Arbitrage? Now, let us proceed to understand Arbitrage Funds.

Arbitrage funds is a type of mutual fund that leverages the price differential in the cash and derivatives market to generate returns. The returns are dependent on the fluctuations of the asset. The arbitrage fund consists more of equity. There is no lock in period as such, but if the amount is withdrawn before 1 month, there is an exit load. It varies from scheme to scheme.

Risk Minimization

Low Risk

Many of you must be wondering, how can a fund that is invested in equity have less risk. This is because of the magic of the market differentiation. When one invests in an arbitrage fund, the fund collected is invested in certain avenues across equity. The fund holds more of an equity portfolio, than debt. So if the funds invested in the equity portion are not performing well, they sell off the share and shift it to an equity avenue, that’s in favor of the market. Hedging is used in an arbitrage fund. This way it minimizes or makes up for the loss.

Let’s look at an example, to understand hedging in a better way. Mr. Lavish invested Rs. 800/- in gold in India, now the prices of gold is reducing, which is causing a loss for Mr. Lavish. However on the other hand, in the US, the price of gold has increased to Rs. 1000 (after conversion into rupees). So Lavish sells the gold in the US, making a profit of Rs. 200.

There are 2 types of arbitrage funds:

  • Growth:This is used for capital appreciation
  • Dividend: There is another option, if a person wants regular income.

An arbitrage fund can also be considered as a liquid fund. It has easy liquidity compared to other funds. If a person needs the funds immediately, then this would be a good option to invest in. Returns generated are also in line with liquid funds. For example, the arbitrage fund category is offering around 5.79% in the last one year, whereas the liquid fund category is offering around 5.68% during the same period.

We have all heard of debt funds and equity funds and the different options available under those funds. Arbitrage funds are less spoken of. When it comes to mutual funds, everyone goes to check for debt funds, equity funds and balanced funds, no one has really heard of arbitrage funds or looks for different options under these funds. This could be due to reasons like, people who don’t want to take risk, think that since equity is involved, risk is automatically associated with. Some may not understand how the fund works or it is too complicated to understand.

We shall now compare and see how an arbitrage fund has an advantage over other funds:

  • Arbitrage funds were always compared with liquid funds, since their returns are similar. Arbitrage Fund has an advantage over Liquid Fund because of its taxability. Arbitrage funds are taxed as per Equity Funds where after a year, the income on such arbitrage funds are exempt upto 1 lac. This change has made liquid funds look less attractive since it is taxed as per debt fund.
  • Equity funds have risk, that’s the reason why people don’t want to invest in equity. In this case, arbitrage funds are used for hedging, this way there’s hardly any risk involved. This fund works best when the market is volatile, as there are many options available.

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