What are arbitrage funds?
An arbitrage fund buys and sells the same security or its derivative in two different markets at different prices to generate risk-free profits for its unitholders.
For example, Reliance Industries (RIL) shares are trading at Rs. 2,400 in the NSE Cash Market and RIL NSE Futures are trading at Rs. 2,450. In this case, the arbitrage fund manager can make a risk-free profit by buying RIL shares at Rs. 2,400 in the NSE Cash Market, where it is priced lower. At the same time, the fund manager will sell the RIL Futures at Rs. 2,450 in the futures market where it is priced higher.
At the time of expiry, the two prices will converge, i.e., the cash market price will move higher, and the futures market price will move lower. Thus, the fund manager will earn a risk-free profit of Rs. 50 per share. Now that we understand arbitrage fund meaning let us see how it works.
How does an arbitrage fund work?
An arbitrage fund manager can take arbitrage positions in three different ways:
- Arbitrage in different market segments of the same exchange
Arbitrage in different market segments of the same exchange works when the price of the same security differs in the cash and derivatives markets. The above scenario of RIL shares that we saw is an example of how the price of the same security can be different in the cash market and derivatives markets, thus presenting an arbitrage opportunity for the arbitrage fund manager.
- Arbitrage in two different exchanges
Sometimes, the same security trades at different prices on two exchanges, thus presenting an arbitrage opportunity for the arbitrage fund manager. For example, the shares of TCS are trading at Rs. 3,850 on the Bombay Stock Exchange (BSE) and at Rs. 3,875 on the National Stock Exchange (NSE).
In this case, an arbitrage fund manager can buy TCS shares on the BSE at Rs. 3,850, where it is priced lower and sell TCS shares on the NSE at Rs. 3,875, where it is priced higher and lock-in a risk-free profit of Rs. 25.
- Arbitrage in index
In this case, the arbitrage is at an index level instead of an individual stock. For example, the Nifty 50 Futures are trading at a level of 18,250, and the equivalent basket of Nifty stocks is trading at levels of 18,200 in the cash market. In this case, the arbitrage fund manager can profit from the opportunity by shorting the Nifty Futures that are trading at a higher level of 18,250 and buying the basket of Nifty shares from the cash market trading at a lower price of 18,200. The arbitrage fund manager can thus lock in a risk-free profit of 50 points on the Nifty trade.
How to invest in arbitrage funds?
You can invest in an arbitrage fund during New Fund Offering (NFO) or any time after. You can invest either in a lump sum or systematic investment plan (SIP). The fund manager invests the money on behalf of investors. The investors are allotted units equivalent to their investments. The net asset value of the units moves up and down as per the value of the securities in the scheme portfolio. An investor’s profit/loss depends on the movement of the scheme’s NAV from the investor’s purchase price.
Role of an arbitrage fund manager
The role of an arbitrage fund manager is to keep looking for arbitrage opportunities, whether it is among two different segments of the same exchange or across two different exchanges. When the fund manager is searching for arbitrage opportunities, the scheme money is invested in fixed-income securities in the interim period. The fixed-income securities earn a regular return on investment.
Who should invest in arbitrage funds?
As an investor, if you have a low-risk appetite and are looking for risk-free returns, then you may consider investing in an arbitrage fund. But, please note that arbitrage opportunities are few, and they don’t last for too long. The past returns given by arbitrage funds are low. So, if you are content with low returns, you may consider investing in an arbitrage fund.
Arbitrage funds tend to provide steady returns across market cycles such as bull phase, bear phase, and volatile phase. During bull phases, usually, futures are priced higher than cash. Similarly, when markets are volatile, stocks usually get mispriced. So, across market cycles, various arbitrage opportunities can arise, which the fund manager can identify and generate returns for investors.
Taxation of arbitrage funds
The taxation of arbitrage funds is similar to that of equity funds.
- Short-term capital gain (STCG) tax: If you sell your arbitrage mutual fund units before 12 months, the capital gain will be classified as short-term capital gain (STCG). The STCG will be taxed at 15%.
- Long-term capital gain (LTCG) tax: If you sell your arbitrage mutual fund units after 12 months, the capital gain will be classified as long-term capital gain (LTCG). The LTCG of up to ₹1 lakh in a financial year will be exempt. The incremental LTCG above ₹1 lakh in a financial year will be taxed at 10% without indexation benefit.
Disclaimer: This blog has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The information/data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this blog are as on date. The blog does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
