Arbitrage funds deserve your attention as an investor seeking to diversify your portfolio and generate income through market-neutral strategies. These specialised mutual funds take advantage of price differences between closely related financial instruments to lock in small profits.
This article provides an overview of how arbitrage funds work, the pros and cons, and the key factors to evaluate to determine the suitability for your needs.
What are arbitrage funds?
Arbitrage funds are mutual fund investment schemes that use cash and derivatives market price differences to generate returns. They buy stocks in the cash market and sell futures in the derivatives market to lock in the price difference.
How do arbitrage funds work?
Here’s how they work:
The strategy
Arbitrage funds invest in securities in the cash market and simultaneously take offsetting positions in the futures and options market to lock in the price differences as risk-free profits. They buy stocks in the cash market and sell futures of the same stock in the futures market at a higher price, pocketing the difference as returns.
Risks involved
While arbitrage funds carry low risk, they are not entirely risk-free. They carry risks related to timing, execution, and liquidity. Timing risk arises if the fund manager fails to execute trades at the right time to capture price differences. Execution risk refers to the possibility of trades not getting executed due to issues like lack of liquidity. Liquidity risk arises from the inability to exit trades when required. However, arbitrage funds have delivered stable returns over time with low volatility.
Things to consider before investing in arbitrage funds
Before investing in arbitrage funds, there are several factors to consider:
Risk involved
While arbitrage funds are considered relatively low risk, there are certain risks to keep in mind:
Market risk: Changes in market conditions can impact the pricing of securities, which may lead to losses. The window of opportunity can close quickly through arbitrage opportunities that aim to generate profits from price differences.
Liquidity risk: At times, the fund may be unable to sell securities at optimal prices due to a lack of liquidity in the market. This can impact returns.
Expense ratio
The expense ratio refers to the annual fees charged by the fund for managing assets. Arbitrage funds’ expense ratios are usually higher than equity or debt funds. Consider if the fees justify the returns.
Taxation
The profits from arbitrage funds are taxed like equity funds for capital gains. Returns may be taxed at a higher rate than interest income. Factor in the tax implications based on your income tax bracket.
Lock-in period
Some arbitrage funds have a lock-in period, during which you cannot withdraw money from the fund. Make sure you understand any exit load fees and lock-in details before investing.
Bottom line
By tapping into price differentials across markets and securities, arbitrage funds can generate solid returns with low volatility. With the right fund choice and realistic expectations, arbitrage funds could be a rewarding part of your investment portfolio.
