A Guide to Arbitrage Fund

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A Guide to Arbitrage Fund

Arbitrage funds are a type of hybrid mutual fund. For investors aiming to expand their investment portfolios, these funds are a popular choice. However, before investing in arbitrage mutual funds, it’s essential to understand what they are, how they operate, their advantages, risks, and other important aspects.

In this blog, we’ll provide our readers with a comprehensive overview of arbitrage funds to help them determine whether these funds align with their investment objectives and preferences.

What is Arbitrage?

Before learning about arbitrage funds, it’s important to first understand what the word "arbitrage" means. Simply put, arbitrage refers to the simultaneous buying and selling of the same asset in different markets to enjoy risk-free returns. 

Suppose a fund buys an asset for Rs 82 in Market X and sells it in Market Y, where the price is Rs 90. In this case, the fund makes a profit of Rs 8 from that asset. These profits are considered risk-free because both the buying and selling are 100% hedged. Since the transactions (buying and selling) happen at the same time, the risk of price changes may get averted.

What is Arbitrage Fund?

An arbitrage fund is an equity-oriented hybrid fund that takes advantage of arbitrage opportunities in the stock market. These could include pricing mismatch between two stock exchanges like NSE and BSE, or different pricing in spot and futures market.

The arbitrage fund manager simultaneously purchases and sells shares, keeping the difference between buying and selling prices. This is different from other investments, which involve buying an asset and waiting for its value to increase before selling it.

The fund manager of an arbitrage fund only makes stock investments when he discovers a clear chance to profit. In the absence of arbitrage opportunities, the fund makes investments in debt securities and short-term money market instruments. Here, it's crucial to remember that the price difference is typically little. Therefore, in order to generate a decent profit, the fund manager must execute multiple deals in a single day.

How Do Arbitrage Funds Work?

Arbitrage funds profit from pricing inefficiencies in the derivatives and cash markets. The transactions are completed immediately on the cash market, often known as the spot market. An asset is sold in futures at a fixed price at a later date. 

An arbitrage fund will therefore purchase a stock in the cash market, sell it in the futures market, and profit risk-free by Rs 5 if the stock is selling at Rs 100 in the cash market and Rs 105 in the futures market. 

Risks Associated with Arbitrage Funds

The best thing about arbitrage funds is perhaps the fact that they are a low-risk investment. As the securities are bought and sold in a simultaneous manner, an arbitrage fund basically removes the risks associated with long-term investments.

Volatility is a good thing for an arbitrage fund. Hence, investors need not stress about the volatility. Arbitrage opportunities will be available as long as the market keeps moving in either direction, and the arbitrage fund managers will be able to generate arbitrage funds returns.

With that being said, arbitrage funds aren’t completely risk-free. Arbitrage opportunities are limited when the markets are trading flat. In such a situation, one of the most common risks associated with arbitrage funds is the potential for below-average profits.

Benefits of Arbitrage Mutual Funds

The benefits of investing in arbitrage mutual funds are as follows:

• These funds are moderately-low risk investments. There is virtually no counterparty risk since each asset is bought and sold simultaneously. Futures contracts are honored, as guaranteed by the clearinghouse, thereby eliminating counterparty risk. 

• Arbitrage funds returns are comparable to those earned from short-term debt.

• Investors are usually reluctant to invest in a volatile market. However, arbitrage mutual funds are known to leverage from volatility in the market.

• Compared to debt funds, arbitrage funds are considered to be more tax-efficient. 

• Arbitrage funds are easy to invest in as they are treated like equity schemes, allowing investors to make lump sum payments or systematic investment plans, depending on their preference.

Conclusion

Arbitrage mutual funds can provide steady returns even when the markets are volatile. Investors who want to invest in a low-risk, moderate-return fund can consider investing in an arbitrage fund after carefully considering the market risks associated with it. 

Want to help investors buy, sell, and manage mutual funds? Connect with Registrationwala to secure Mutual Fund Distributor License from the Securities and Exchange Board of India (SEBI).

Disclaimer: Registrationwala is not responsible for any losses incurred by individuals investing in arbitrage funds or any other financial instruments. We do not provide investment recommendations. All investment decisions are the sole responsibility of the investor. Please consult a financial advisor for personalized advice.

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