Arbitrage funds have emerged as a popular investment option for many Indian investors seeking moderate returns with relatively lower risk compared to pure equity funds. Arbitrage funds aim to generate steady returns by leveraging pricing inefficiencies between equity markets and derivatives markets.
What are arbitrage funds?
Arbitrage funds are open-ended mutual fund schemes that take advantage of differential pricing for the same asset trading in different markets. For example, when futures contracts of a stock are overvalued compared to the underlying stock trading in the spot market, the fund manager will simultaneously buy the stock in the spot market while selling futures in the derivatives market. This helps lock in the arbitrage spread from the pricing gap between the two markets.
As arbitrage funds look to profit from price discrepancies rather than market direction, they carry lower risk than conventional equity funds. At the same time, arbitrage funds target moderately higher returns than fixed income funds by exploiting arbitrage opportunities. The key is to hedge the exposure using derivatives to minimize directional risk.
Types of arbitrage strategies
Fund managers employ various types of arbitrage strategies based on prevalent opportunities and market conditions:
- Index arbitrage – This involves arbitraging the pricing differences between index futures like Nifty futures compared to the underlying basket of index constituent stocks. Funds buy/sell the index while simultaneously selling/buying the individual stocks to lock in risk-free arbitrage gains.
- Cash futures arbitrage – Here the fund manager exploits the mispricing between single stock futures and the underlying shares. When futures are overpriced, the fund buys shares in spot and sells equivalent futures to pocket the spread.
- Corporate bond arbitrage – This strategy taps the spread between corporate bonds and gilt securities of similar maturity. Funds buy the lower yielding bonds while shorting the higher yielding securities.
- Multi-asset arbitrage – Under this, fund managers identify and combine arbitrage opportunities across various assets like equities, bonds, currencies and derivatives to construct an optimal market-neutral portfolio.
Based on prevailing market signals, fund managers actively employ the most profitable arbitrage strategies at any point.
Risk and return profile
The risk profile of arbitrage funds lies somewhere between fixed income and equity schemes. The hedged arbitrage positions make them less risky than direct equity investments. However, some market risk remains due to fluctuations in spreads and volatility. Liquidity risks also exist in case of thinly traded securities.
Hence, arbitrage funds are typically rated as moderate risk investment options. They carry relatively lower risk than pure equity schemes. However, arbitrage funds are not completely risk-free and see marginally higher risks than liquid funds or ultra-short bond funds.
In terms of returns, arbitrage funds aim to generate steady annual returns in the range of 6-9% based on successfully capturing spreads. The returns are more stable than equity funds but lower than the best performing debt funds. Arbitrage fund returns have low correlation with equity and debt assets, making them an effective diversifier.
Taxation and lock-in
Most arbitrage funds have a lock-in and levy an exit load if units are redeemed before a month or year. This ensures adequate time for the fund manager to capture spreads on arbitrage positions.
For taxation, arbitrage funds are treated like equity funds. Long term capital gains over 1 year are taxed at 10% while short term gains under 1 year are taxed at 15% as per income tax rules. Dividend payouts from arbitrage funds are tax-free in the hands of investors.
Assessing the fund manager’s capability, portfolio composition, risk management and overall market conditions is important before investing. Used prudently within asset allocation limits, arbitrage funds can enhance portfolio diversification and risk-adjusted returns for investors suited to their moderate risk-return profile.