Investing can sometimes feel like sailing through rough waters. Some people are ready to take big chances for bigger rewards, while others look for steady income, safety, and keeping their money secure. For those who prefer the latter, arbitrage funds have become a popular choice. But what are they really, and how do they function? In this blog, we`ll explain what arbitrage funds are, how they work, their advantages, possible risks, and why they might be a good fit for your investment plan.
What is an Arbitrage Fund?
An arbitrage fund is a kind of mutual fund that makes money by taking advantage of price differences in different markets. Basically, these funds purchase an asset in one market where it`s cheaper and then sell it in another market where it`s more expensive. The profit comes from the difference between the price paid and the price received.
These funds are generally seen as low-risk because they use hedging strategies. They don`t rely on predicting market trends like regular equity funds. Instead, they focus on finding and using small pricing differences between markets to make steady returns.
How Do Arbitrage Funds Work?
To understand arbitrage funds, let`s look at a simple example:
Imagine a company`s stock is priced at Rs. 1,000 on the National Stock Exchange (NSE), but it`s showing a price of Rs.1,020 on the Bombay Stock Exchange (BSE). An arbitrage fund manager can:
- Buy the stock at Rs. 1,000 on the NSE.
- Simultaneously sell it at Rs. 1,020 on the BSE.
The difference of Rs. 20 per share becomes profit, minus transaction costs.
Arbitrage opportunities often happen during corporate events such as mergers, acquisitions, rights issues, or when companies announce dividends. These events can cause stock prices to differ briefly between cash and derivatives markets.
Today`s arbitrage funds use advanced technology and smart algorithms to quickly identify these chances as they happen. Although it`s hard for individual investors to take advantage of these small price differences, arbitrage funds are able to do it efficiently and with expert knowledge.
Types of Arbitrage Funds
Arbitrage funds are broadly categorized based on their investment strategies:
1. Equity Arbitrage Funds:
These funds take advantage of the difference in prices between buying stocks directly and using derivative products like futures and options. For example, they might purchase shares in the regular market and at the same time sell futures contracts that match those shares.
2. Merger Arbitrage Funds:
These funds invest in companies that are merging or being bought by another company. When a company announces it will be taken over, the stock price of the company being acquired usually doesn`t immediately jump to the agreed-upon price. Arbitrage funds take advantage of this by buying the stock at a lower price and then selling it once the merger is finished.
3. Convertible Arbitrage Funds:
These funds put money into convertible bonds, which can be turned into company shares at a set price. The fund makes money from the difference in value between the bond and the actual stock.
4. Fixed Income Arbitrage Funds:
These funds look at the differences in interest rates and bond prices for different maturity dates or types of debt. This type of fund isn`t very common in regular investor markets, but it`s often used by bigger investment firms.
Key Benefits of Arbitrage Funds
Arbitrage funds are increasingly attractive to conservative investors due to the following benefits:
1. Low Risk:
These funds protect against risks in cash and derivatives markets, so they have less risk than regular equity funds. They are sometimes called similar to hybrid funds, but they are more stable.
2. Consistent Returns:
Arbitrage funds try to give steady returns that are not too high, usually between 6% and 9% each year, based on how the markets are doing.
3. Tax Efficiency:
In India, arbitrage funds are treated as equity funds for tax purposes. This means:
- Short-term capital gains (STCG) under 1 year are taxed at 15%.
- Long-term capital gains (LTCG) over 1 year are tax-free up to Rs.1 lakh.
Compared to debt funds, which are taxed at regular income tax rates, arbitrage funds can be more tax-efficient.
4. Liquidity:
Since they are mutual funds, arbitrage funds let investors sell their units whenever they want, which means they are more liquid than regular fixed deposits or corporate bonds.
5. Ideal for Conservative Investors:
They provide a way to invest in shares with less risk, which makes them good for people who want a bit more return than savings accounts but don`t want to face big market risks.
Risks and Considerations
No investment is completely safe, and arbitrage funds are not different. Even though they carry less risk, there are a few things you should think about.
1. Market Risk:
Though hedged, extreme market volatility or sharp price gaps can lead to losses.
2. Interest Rate Risk:
Some arbitrage chances include short-term loans or financial tools that change with interest rates.
3. Lower Returns in Calm Markets:
Arbitrage funds make money by taking advantage of differences in prices between markets. When markets are very efficient or don`t move much, there are fewer chances to find these price differences, which can result in smaller profits.
4. Costs and Expenses:
Trading derivatives and stocks often leads to costs from each transaction, which can lower the overall profit. It`s important to pick a fund that has a low fee for managing the investments.
Who Should Invest in Arbitrage Funds?
Arbitrage funds are ideal for:
- Conservative investors seeking slightly higher returns than fixed deposits.
- Investors with a 1-3 year horizon who want stability and liquidity.
- Tax-conscious investors looking for equity taxation benefits without high market risk.
- Investors looking for a parking place for short-term surplus funds.
These funds might not be the best choice for investors who want big gains and are willing to take more risk, because arbitrage funds focus on steady growth instead of huge returns.
How to Invest in Arbitrage Funds
Investing in arbitrage funds is straightforward:
- Research: Compare fund performance, expense ratios, and past consistency.
- KYC Compliance: Complete Know Your Customer (KYC) formalities.
- Choose a Fund: Decide on a lump-sum or SIP (Systematic Investment Plan) investment.
- Monitor Performance: Although these funds are low-risk, you should check how their returns compare to FDs and other options.
Conclusion
Arbitrage funds offer a unique mix of stability, ease of access to cash, and steady growth. They sit between stocks and bonds, giving cautious investors a secure way to get better returns than what is usually offered by standard interest-bearing investments.
2026(22)
