Arbitrage Funds: Meaning, Benefits & Drawbacks

The share market is volatile and from time to time, the volatility level gets too high to intimidate many investors. Naturally, people would hesitate to invest in equities when the market is too volatile. But there are options where one can make profits even in this uncertain scenario. One such option is the arbitrage mutual fund. As it is a derivative of the word ‘arbitrary’, the nature of arbitrage funds are pretty much the same but even then you will find a consistent logic within it. So, let us understand what this arbitrage fund is and how it can help investors in making a profit in a highly volatile market. 

What is Arbitrage Fund?

Arbitrage funds belong to the general category of mutual funds but they are slightly different in nature from other mutual funds. These funds are created by the process of differences that are simultaneously taking place between the equity share markets and the futures markets. The fund managers of arbitrage funds constantly buy and sell the equities between equity markets and futures to generate profits. 

How Does Arbitrage Fund Work?

Let us take an example to understand the working process of arbitrage funds. Suppose ABC has equity shares that can be traded at Rs 1000 in the cash market (also known as the spot market) and at Rs 1100 in the futures market. Now, what the fund manager will do is that he will sell the shares in the futures market and generate a profit of Rs 100. Similarly, if the value of shares in the spot market is higher, then the fund manager would first purchase shares from the futures and sell them in the spot market to generate profits. 

This process keeps continuing in the arbitrage fund and that is how fund managers are able to generate profit even in a highly volatile market. 

Who Should Invest in Arbitrage Funds?

If you are someone who wants to make a profit without exposing your money to high risk, then arbitrage funds are one of the options to go for. It is ideal for people who want to keep a short to medium-term goal. An important thing to keep in mind about arbitrage funds is that the profit that is made cannot be exceedingly high because the difference in the price between spot and futures cannot be that high. 

Benefits of Arbitrage Funds

Arbitrage funds is an interesting prospect for many investors and there are several benefits of investing in them:

  • The level of risk associated with arbitrage funds is very low. The profits that you make are made out of constant buying and selling of equities between the two markets. Hence, the possibility of losing out on your investment is minimal. 
  • When it comes to taxation, arbitrage funds work very much like equity shares. If you hold an arbitrage fund for more than a year and then make a profit out of it, the gained amount will be considered as the long-term capital gain. And the interest rate will be charged on it at the rate of 10% which is much lower than the regular income tax rate. 

Drawbacks of Arbitrage Funds

There are certain downsides to arbitrage funds as well. They are as follows: 

  • The returns that the arbitrage funds provide are pretty mediocre. One of the major drawbacks of these funds is that they cannot perform well when the market is stable. If the market remains stable for a long time, the actively managed equity shares can provide a much better return than arbitrage funds. 
  • As these funds need to be constantly traded between the markets, the fund manager would charge a higher fee for them. That is why the expense ratio of arbitrage funds is quite high in comparison to other mutual funds. 

Arbitrage funds are an interesting form of investment but to make it that you will have to take heed of the market dynamics. Only when the market is volatile can you reap the advantage of these funds. Otherwise, it is better to invest elsewhere.