What are arbitrage funds? How they work, who should invest, and other details

Arbitrage funds are defined as low-risk hybrid mutual funds that generate profits by exploiting price differences of the same asset between different capital markets, such as the cash and derivatives (future) markets. They typically buy shares in the cash market and simultaneously sell them in the future market, locking in a profit regardless of the market direction.

Classified as equity-oriented, these funds can trade in equities, while also deploying money in debt, and money market instruments. According to Securities and Exchange Board of India (Sebi) guidelines, arbitrage funds must invest at least 65% of their funds in equities.

A spot (or cash) market is where buyers and sellers agree on a price and settle the transaction immediately, with the asset exchanged for cash. In contrast, a futures market involves agreeing to a price today on a price for a transaction that will take place at a specified date in the future, through a binding contract.

Gains from units sold within 12 months, considered short-term capital gains (STCG) are taxed at 20%, while profits held for over 12 months, which are long-term capital gains (LTCG) are taxed at 12.5%. These taxes apply on gains exceeding ₹1.25 lakh per financial year.

How arbitrage funds work?

For instance, if the share of a company is trading at ₹500 in the cash market and ₹510 in the futures market, then the fund manager buys shares from the cash market and creates a futures contract to sell the shares at ₹510. This allows the fund to lock in a spread of ₹10 per share (before transaction costs).

Though the earlier example showed that the fund can make a modest profit in the futures market, that may not always be the case. If the price of the company's share surges to ₹550 on the date of expiry of the futures contract. Then you would make a profit of ₹50 in the cash market and a loss of ₹40 in the futures market. Overall, you will still make a profit of ₹10.

If the price of the share goes down to ₹400, then you would incur a loss of ₹100 in the cash market, but make a profit of ₹110 in the futures market. Your profit is ₹10 per share again. If the prices do not change at all, you still make Rs. 10 per share in the futures market. This is how arbitrage funds take advantage of price difference in different markets and earn profits.

Arbitrage Funds have virtually no price risk, as the equity exposure of these funds is wholly hedged. However, investors must understand that much like other market-linked instruments, there is no guarantee of gains, according to a report by Mutual Funds Sahi Hai.

What investors must know before investing in arbitrage funds?

While arbitrage funds are designed to minimise price and counterparty risk through hedged positions, they are not entirely risk-free. The debt portion of these funds can still be exposed to credit risk.

Moreover, these funds may not perform well in bearish markets, as futures often trade at a discount to cash prices, Mutual Funds Sahi Hai said in a report. Here's everything investors should know:

• Short-to-medium term investment goals: Arbitrage funds provide reasonable returns, hence they are suitable investments if you want to make money in the short- to medium term. These funds are best suited to investors with an investment horizon of 3-6 months.
• Investment amount: It is better to invest in these funds through a lumpsum amount rather than systematic investment plans (SIP).
• Read scheme offer document: Before making an investment in an arbitrage fund, you must read the scheme offer document carefully, as it contains crucial details about the investment objective, investment strategy, risks, asset allocation, and fees associated with the fund.
• Asset allocation: Arbitrage funds invest in a combination of equity and debt instruments, hence it's important for individuals to understand the asset allocation of the fund. Based on that, you can assess whether it aligns with your investment goals and risk appetite.
• Management fees: Like all mutual funds, arbitrage funds charge a management fee for managing the fund. This fee is charged as a percentage of the assets under management and is deducted from the returns generated by the fund.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.