EduFund

Demystifying Arbitrage Funds – a suitable option in volatile times?

We work our fingers to the bone to save and invest for our future self or for our future generations. As investors, the biggest nemesis to our portfolio is the unstable market or an extremely volatile, ever-changing market. What if we told you, that there are funds that thrive in such conditions?

An arbitrage fund is a kind of mutual fund, where the fund manager hunts for price differences in the spot market (cash market) and future market (derivates market) to perform the arbitrage.

This fund ensures profit in volatile markets with minimal risk. These funds are highly suitable for conservative or risk-averse investors. Too much to handle? Read on to navigate through this financial labyrinth.

To demystify this financial product, we need to start by understanding the term Arbitrage.

What is Arbitrage?

Arbitrage in a simple sense is a transaction or a trade where a commodity or security is purchased and sold in the same time frame in order to profit from the price difference. For example, a fruit retailer would purchase Apples from Kashmir for Rs.100/kg and sell them in Mumbai for Rs. 200/kg.

Here, the retailer has made an arbitrage by purchasing and selling the commodity in different markets. Similarly, a stock of ABC company is trading at $100 on stock exchange A but is trading at $102 on stock exchange B. As a rational investor (provided that it is legally allowed in the country), I would buy from stock exchange A and sell it at B, hence pocketing a profit of $2. 

The opportunity of arbitrage also presents itself in the price difference of securities in the spot and futures markets. Spot market refers to the public financial market where the securities or commodities are traded to receive an immediate delivery.

For example, if the price of stock ABC is INR 2350, one can purchase this stock and secure the ownership of the company immediately. Whereas, in the futures market the trades are locked for delivery at a specific date in the future, and the price is determined by the market view of the stock.

Hence, if you are buying a share in the future market that has a maturity at the end of 1 month, then the share is delivered to you at the end of maturity (whereas in the spot market, it comes into your possession immediately).

Pricing of the stock in the future market can be illustrated from this example: The price of stock ABC is INR 2350 in the cash/spot market. However, the market feels that the company has a great potential for growth or there is an expectation that the stock would see a potential increase in the next two months, then future contract delivering these shares at the end of two months would be highly valued of a price say, INR 2700.

Back to Arbitrage Funds

Arbitrage funds are equity funds that employ an active strategy – buying and selling during the downturns to deliver good returns. They hence turn volatility, your nemesis, into your friend-in-need. How do these funds do that? Volatility causes chaos and uncertainty in the markets and in the minds of the investors. This leads to a large price differential in the future and spot market, hence opening up an opportunity for arbitrage.

These funds also allocate ~10% or higher of the asset value into debt instruments which are considered stable. In a stable market condition where the opportunity of arbitrage is lesser, this allocation is altered, and the fund invests more in the highly stable debt securities – becoming a bond fund or a debt fund – would have a large impact on its profitability. This makes it a product that is highly suitable to the risk-averse investor and investors who want to benefit from the volatility. 

In a typical mutual fund, the securities are purchased with a view that the prices would increase over a period of time. However, in an Arbitrage fund, when the market is bullish or optimistic for the future, (which implies a potential growth in prices), the fund buys the stock in the cash market and sells it in the future market, hence pocketing the profit, Cha-Ching!

Similarly, when the market is pessimistic or is taking a downturn, the fund buys the future contracts which would be priced lower and then sell these shares in the spot market, where it would get a higher price – Cha-Ching again!

Conclusion 

These funds are suitable for a medium time horizon of 1- 3 years, where you are saving to get that Gaming laptop that you always wanted or to buy that beautiful lehenga for your wedding or to fund any expense in the foreseeable time horizon. Reason: Because the volatility over a longer period of time would appear smoother, making other options superior investment alternatives.

Arbitrage funds also have a higher expense ratio (management fees paid to the fund) than the typical mutual funds. Reason: The profit made from the arbitrages is marginal and hence requires a large number of transactions to be executed to have a sizable gain. Hence, the fund charges you a higher fee than the regular mutual funds.

The exposure to risk is very minimal as the purchase and sale trades occur almost simultaneously. As there would be a dearth of arbitrage opportunities as the prices in cash and futures markets converge, one would have to invest in other instruments to augment their overall returns.

These funds are treated as equity-related instruments. Hence the funds are taxed at capital gains tax depending on the holding period. 

a) If the holding period is >1 year – Returns earned are subject to long-term capital gains tax – 15%.

b) If the holding period is <1 year – Returns earned from the fund are liable to a short-term capital gains tax -10%.

A little more Financial Gyan

To choose one of the many arbitrage funds available in the market, assess them on the following factors –

  1. Performance Consistency over the last 3 years
  2. 1 Year returns
  3. How much has it outperformed the benchmark?
  4. Expense Ratio
  5. Asset Size 

EduFund