To understand how an arbitrage fund operates, let us first understand what is the meaning of arbitrage — simultaneously buying and selling the same asset across different markets to capitalise on slight price discrepancies.
What is 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.
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.
How arbitrage funds operate
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, the fund incurs a loss of Rs 15 per share in the spot market but simultaneously gains Rs 25 per share in the futures market. The fund's overall profit from the transaction increases to Rs 10 per share or Rs 50,000.
Arbitrage across exchanges and indices
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 by purchasing on the BSE and selling on the NSE, securing a risk-free profit of Rs 25 per share.
Arbitrage opportunities can also manifest at the index level. If the Nifty 50 Futures are priced at Rs 21,550 while the equivalent basket of Nifty stocks trades at Rs 21,500 in the cash market, a manager can short the Nifty Futures and buy the cash basket, locking in a risk-free profit of 50 points.
Who should consider arbitrage funds?
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.
The good part is that arbitrage funds delivered consistent returns across different market phases like 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%.
| Fund | Since Inception | 1 Year | 5 Year |
|---|---|---|---|
| HDFC Arbitrage Fund | 6.47% | 7.51% | 5.01% |
| SBI Arbitrage Opportunities Fund | 6.71% | 7.71% | 5.17% |
| Tata Arbitrage Fund | 5.31% | 7.41% | 5.28% |
