Conservative buyers prefer safer investment options and may think that fewer options are available for them to invest. But the fact that there are different kinds of mutual funds available offers them a wide variety of choices, like Arbitrage funds. Investors have other advantages as well, apart from low-risk returns, like tax benefits. The price difference spread forms the basis of generating profit.
Let us walk you through this article to build your understanding of arbitrage funds, their features that make them a unique choice, and whether they are really as risk-free as you think.
What Are Arbitrage Funds?
Arbitrage funds are one kind of hybrid mutual fund, which uses price differentials in securities across various markets or market segments to produce returns. These funds take advantage of the difference in price between the same asset’s spot price on the cash market and its futures price on the derivatives market.
Features:
- Price Differential Strategy: By taking advantage of price variations between the cash and futures markets, profits can be made.
- Hedged Positions: To lower directional market risk, every equity purchase is accompanied by a futures sale.
- Low-Risk Profile: Although not completely risk-free, their market-neutral approach makes them safer than equity funds.
- Gains Driven by Volatility: Increased market volatility enhances arbitrage opportunities and profits.
- Moderate Returns: Typically offer 4%–7% annually, with greater stability than equity funds. However, returns can vary based on market conditions.
- Short to Medium-Term Suitability: Best suited for six to twelve-month investment horizons.
Why Investors Opt for Arbitrage Funds?
In times of market uncertainty, arbitrage funds are frequently regarded as a safe haven due to the following reasons:
1. Minimal Risk Profile
- Since every buy position is counterbalanced by a sell position, risk is essentially hedged, making it a minimal risk profile.
- When the price differential between the spot and futures markets widens, the potential for arbitrage profit increases. Moderate market volatility often helps create these opportunities, though excessive volatility can pose risks.
2. A Low-Risk Substitute for Equity Funds
- Ideal for cautious investors looking for equity exposure without the volatility of the stock market.
3. Consistent and Reliable Returns
- Because they rely on arbitrage spreads rather than market direction or speculation, arbitrage funds generally offer more stable returns, though these can vary depending on market conditions.
- Arbitrage funds, in contrast to most funds, profit from volatility. They view the volatility as an opportunity more than a threat by using it to expand spreads and lock in larger gains.
4. Comparison with Alternate Funds that are Liquid:
| Parameter | Arbitrage Funds | Liquid Funds |
| Average Return | 4.5–7% (tax-efficient) | 5–6% (taxable as income) |
| Risk Level | Low | Very Low |
| Taxation | Taxed as Equity | Debt (as per income tax slab) |
| Ideal Holding Period | 6–12 months | A few days to 3 months |
Are They Really Risk-Free?
Let’s examine if arbitrage funds are really as risk-free as they appear to be:
1. Inefficiency of the Market Reliance
Arbitrage funds are based on the price difference between cash and the future market. There is a specific term for this difference, called spread. When the spreads get narrow:
- The arbitrage opportunities become limited.
- The net returns become even lower than normal savings accounts after deducting the expenses that an investor bears
2. Risk to Liquidity
Even though arbitrage fund assets are typically liquid, the fund manager may be forced to unwind positions too soon if investors suddenly make large redemptions. This can:
- Break the hedging plan.
- Cause losses to be booked rather than waiting for arbitrage profits to appear at expiration.
3. Risks Associated with Operations and Costs
Arbitrage strategies entail frequent buying and selling in both spot and futures markets, despite their theoretical low risk. This results in:
- Greater expense ratios in contrast to overnight or liquid funds.
- Transaction fees that reduce returns include STT, broking, and stamp duty.
- Tracking errors brought on by timing discrepancies when buy and sell orders are executed.
4. Sensitivity to Interest Rates
Arbitrage funds allocate a portion (15–35%) to short-term debt or money market instruments for liquidity, even though they do not invest in long-duration debt instruments. If there is a significant drop in interest rates:
- This section may yield lower returns.
- This may have an effect on the overall return profile, particularly when there is little arbitrage activity.
Bottomline
The conclusion can be drawn that arbitrage funds may have less risk, but calling them completely risk-free may be deceiving. Understand that the investment option you are choosing holds utmost importance to generate returns. Arbitrage funds may be a better alternative than other liquid funds, but they have their own setback.
So, deciding whether to invest in them or not solely depends on your investment profile. Analyse the duration you want to invest, the need for liquidity that is required, and the returns you are expecting.
Written by: Tanya Kumari
