Understanding Arbitrage funds and who should invest in them

To understand how an arbitrage fund operates, let us first understand what is the meaning of Arbitrage. 

Arbitrage is the practice of simultaneously buying and selling the same asset across different markets to capitalise on slight discrepancies in prices. The aim is to generate profit without taking on any significant risks. This strategy involves purchasing the asset where it’s priced lower and selling it where it’s priced higher.

Now let us understand what arbitrage funds do.

Arbitrage funds are hybrid mutual fund strategies that leverage price differentials among the same underlying assets across various capital market segments to yield arbitrage returns. These funds also invest in debt and money market products.

When the price of a particular security varies between the cash and derivatives markets within the same exchange, arbitrage opportunities arise.  

Suppose that an arbitrage fund purchases 5,000 shares of company A at Rs 500 per share for Rs 25,00,000. It also simultaneously sells 5,000 shares in the futures market at Rs 505. This move effectively locks in a profit of Rs 25,000 (5 x 5,000 shares) for the fund. The fund stands to gain Rs 25,000 when the futures contract matures.

However, if market sentiment takes a downturn and prices decline, with spot market shares trading at Rs. 485 and futures market shares at Rs. 480.

In this scenario, while the fund incurs a loss of Rs. 15 per share (Rs. 500 – Rs. 485) in the spot market, it simultaneously gains Rs. 25 per share in the futures market (Rs. 505 – Rs. 480). As a result, the fund’s overall profit from the transaction increases to Rs. 10 per share (₹25 – ₹15) or Rs. 50,000 (₹10 x 5,000 shares).

At times, identical securities are priced differently across two distinct exchanges, creating arbitrage prospects for fund managers. For instance, consider ABC shares trading at Rs 1,000 on the Bombay Stock Exchange and Rs 1,025 on the National Stock Exchange. 

An arbitrage fund manager can exploit this situation by purchasing ABC shares on the BSE at a lower price and selling them on the NSE at a higher price, thereby securing a risk-free profit of Rs. 25 per share.

Arbitrage opportunities can also manifest at the index level rather than individual stocks. For example, if the Nifty 50 Futures are priced at Rs 21550, while the equivalent basket of Nifty stocks trades at Rs 21500 in the cash market, an arbitrage fund manager can capitalise on the price difference. 

By shorting the Nifty Futures at the higher level and simultaneously buying the basket of Nifty shares from the cash market at a lower price, the manager can lock in a risk-free profit of 50 points on the Nifty trade.

If you’re considering investing in an arbitrage fund, you should know that it is a low-risk option. Arbitrage opportunities are limited and short-lived and provide very modest returns. Therefore, if you’re comfortable with the prospect of low risks with lower returns, arbitrage funds could be a viable option for your investment portfolio.

However, the good part is that arbitrage funds delivered consistent returns across different market phases like the bull markets, bear markets, and even during periods of high volatility. 

Taxation of Arbitrage funds

Arbitrage funds are classified under the equity schemes for taxation purposes. If you make an investment in arbitrage funds for less than a year, any gains are classified as STCG (Short Term Capital Gains) and taxed at a 15% rate. If you keep your investment for over a year, the gains are considered as LTCG (Long-Term Capital Gains) and taxed at a rate of 10%.

Comparison between the top 3 Arbitrage Funds

Here is a comparison of the returns that HDFC, SBI and Tata Arbitrage funds have generated over the years. SBI arbitrage funds have outperformed the other two funds by 0.2%.