What are Arbitrage Funds?
Arbitrage funds are a category of mutual funds that operate on the basis of differences in prices between different markets. Experts point out that they could be significant for short-term investment strategy.
Kolkata: Mutual funds have become the darling of the investing masses in India. Arbitrage funds are a type of hybrid mutual fund whose target is to profit from the difference in price between the cash market and futures market. The usual mode of operation consists of buying securities in the cash market and selling the securities in the futures market and doing it at the same time.
It is often seen that the price of a security in the cash market is less than the price in the futures market. Therefore, even if the market is volatile, arbitrage funds can lock in the price differential as the gains, by simultaneously exploiting the difference. For every arbitrage fund the primary goal is to lock in returns with relatively lower risk compared to other investment strategies. A finance professional who is involved in arbitrage operation is known as an arbitrageur.
Types of arbitrage funds
There are a few common types of arbitrage strategies that fund managers employ. These are:
- Cash-futures arbitrage: This is a trading strategy that exploits price differences between the cash market and futures market for the same asset. Therefore, the first step is to identify situations where the price of a stock or commodity in the spot/cash market differs from that in the futures market. Then fund managers buy it in the cash segment and sell a futures contract of the same asset.
- Equity arbitrage: As the name suggests, the strategy revolves around stocks.
- Index arbitrage: In this strategy, the manager takes advantage of the price difference between the stocks constituting an index and the price of the index itself. The fund manager buys and sells the stocks and index futures and gains from it.
- Cross-market arbitrage: Arbitrageurs can try out buying and selling the same asset in different markets/exchanges. The difference between the buying price and selling prices, after adjustment for transaction cost, signals the gain. It is related to market inefficiencies, when price differences are take place on account of differences in information flow, investor sentiment, and liquidity. Global equity arbitrage, where price differentials for the same stock on different stock exchanges, and cross-currency arbitrage, where differences in the prices exist due to exchange rates between different currencies, are common examples.
Advantage of arbitrage funds
Experts point out a few advantages of investing in an arbitrage fund. These are:
- Less risk: The risk of investing in an arbitrage fund is low. Since the fund manager is aware of the buying and selling price, he/she can take calculated positions that are clear before executing the deal.
- Suited for a volatile market: In a situation where the market is marked by continuous volatility, arbitrage funds can be a good option for investing. The reason: since the fund manager knows the prices beforehand, he/she is not really impacted by volatility.
- Balanced funds: Arbitrage funds are a type of hybrid fund. It has a focus on equity but also involves debt components and thus creates a balance of both asset classes.
- Tax advantage: For arbitrage funds, gains are subjected to income tax at 12.5% if the investor holds on to the investment for more than two years. If one considers a debt fund, the taxation takes place at the general slab rate of the individual, whatever the holding period. For those who are in the higher tax slab rates, investing in arbitrage funds seems to be more tax efficient.
There is a point to note. Arbitrage opportunities are not high all the time. When arbitrage opportunities are considered low, the fund manager can invest some of the capital into debt instruments, which are inherently less prone to fluctuation and are safe. Fund managers fish out debt paper that have a high credit rating such as bonds or highly-rated corporate debt paper.
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