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What are Arbitrage Funds? Meaning, How It Works, Benefits & Risks
Arbitrage Funds are open-ended mutual funds. These funds as per SEBI guidelines are mandated to hold at least 65% of its assets in equities and equities related instruments in the portfolio. It aims to make potential gains using arbitrage strategy. It belongs to the hybrid fund category, but because its net equity exposure is above 65%, it is taxed like an equity fund.
Definition of Arbitrage Funds
An arbitrage fund is a mutual fund that exploits temporary pricing inefficiencies between the cash (spot) market and the derivatives (futures) market. Such disparities often arise due to shifts in market sentiment, supply–demand mismatches, or sudden volatility. The fund manager simultaneously buys a security in the spot market and sells its corresponding futures contract, thereby locking in the price difference. Since these positions are hedged, arbitrage funds significantly reduce exposure to market direction, making them a relatively low‑risk alternative to traditional equity investments.
How Do Arbitrage Funds Work?
The working mechanism of an arbitrage fund is rooted in capturing the difference between the spot price and the futures price of the same security. When the futures price trades at a premium relative to the spot price, the fund manager purchases the stock in the cash market and sells its futures contract at the higher price. The spread between the two becomes the fund’s secured profit, irrespective of market movements thereafter.
For instance, if a stock is priced at ₹1,000 in the spot market while its futures contract trades at ₹1,020, the fund buys the former and sells the latter. This locks in a gain of ₹20, which is realized upon contract expiry. During periods of lower volatility, when arbitrage opportunities are limited, the fund may allocate a portion of its portfolio to short‑term debt or money market instruments. This ensures liquidity and stability, although it may slightly temper returns.
Benefits of Investing in Arbitrage Funds
Arbitrage funds offer several benefits to investors.
- Professionally managed for risk‑adjusted returns: Arbitrage funds are managed by experienced professionals who continuously scan the markets for price discrepancies using detailed research and systematic strategies. Their expertise helps capture genuine arbitrage opportunities while keeping overall risk low, enabling the fund to aim for stable, risk‑adjusted returns.
- Reduced volatility impact for potential returns: The hedged strategy significantly reduces volatility, making them a safer choice compared to pure equity funds. During periods of heightened market fluctuations, the number of arbitrage opportunities tends to rise, allowing these funds to potentially deliver reasonable returns.
- Gets equity tax treatment efficiently: One of the key attractions of arbitrage funds is their tax efficiency. Because their equity exposure exceeds 65%, they are taxed as equity funds. Short‑term gains (up to one year) are taxed at the investor’s income tax rate, while long‑term gains beyond one year are taxed at 12.5%. This can make arbitrage funds more tax‑friendly compared to liquid or short-term debt funds, particularly for investors in higher tax brackets.
- Risks of Investing in Arbitrage Funds: Despite their low‑risk profile, arbitrage funds are not entirely free from challenges.
- Unavailability of arbitrage opportunities: Their primary risk lies in the availability of arbitrage opportunities. When markets are highly volatile, opportunities abound; however, during calmer phases, pricing differences narrow, reducing the potential for meaningful gains.
- Dampened liquidity conditions: Moreover, sudden shifts in liquidity conditions—especially during volatile periods—can hinder the execution of arbitrage trades, affecting overall returns.
- Returns taking a hit: A small portion of the fund may be invested in debt instruments, introducing limited interest rate or credit risks. Investors may also observe minor daily NAV movements due to mark‑to‑market adjustments on futures positions. As a result, arbitrage funds do not guarantee returns, and performance may be inconsistent during extended periods of low volatility.
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