What is Arbitrage Fund

Arbitrage Funds represent a unique approach within the realm of investing. These funds, falling under the category of equity-oriented hybrid funds, capitalize on market arbitrage opportunities. These opportunities can stem from various disparities such as pricing mismatches between exchanges or variations between spot and futures markets.

The modus operandi of an arbitrage fund's manager involves simultaneous buying and selling of shares to profit from the price differentials. This starkly contrasts with traditional investing, where one typically waits for asset values to appreciate before selling.

In essence, the fund manager of an arbitrage fund meticulously seeks out opportunities for equity investment, executing trades only when promising returns are imminent. Should arbitrage opportunities be scarce, the fund redirects its investments towards short-term money market instruments and debt securities. It's worth noting that the profit margins in arbitrage tend to be narrow, necessitating numerous trades within a single day to accrue substantial gains 

Features of an Arbitrage Fund 

The major features of an arbitrage fund are:

(i)             They are Equity-oriented : Equities and equity-related products must account for at least 65% of the portfolio.

(ii)            Provide Hedged Exposure : The portfolio will primarily contain hedged exposures.

(iii)          Low-risk Funds : These funds have the potential to outperform non-equity-oriented funds in terms of post-tax returns.

(iv)           Suitable in Unstable Markets : Such funds are the only low-risk investment that thrives in a volatile market.

How Does an Arbitrage Mutual Fund Work?

Let's look at the two possible scenarios where arbitrage opportunities exist:

Scenario #1: Price Difference between Exchanges

Let's say that the stock of XYZ Limited is selling at Rs. 1000 per share on the Bombay Stock Exchange (BSE) and at Rs. 1010 per share on the National Stock Exchange (NSE).

If the fund manager of an arbitrage fund spots this opportunity, then he buys shares from the BSE and simultaneously sells them on the NSE. This allows him to make a profit of Rs. 10 per share (less transaction costs) without any risks.

Scenario #2: The Price Difference between the Cash and Futures Markets

Let's say that the share of XYZ Limited trades at Rs. 1000 in the cash market and Rs. 1015 in the futures market. The fund manager of the arbitrage fund buys shares from the cash market and creates a futures contract to sell the shares at Rs. 1015. At the end of the month, he sells the shares in the futures market and books a profit of Rs. 15 per share (less transaction costs) without taking any risks.

How Should You Invest in an Arbitrage Mutual Fund?

You can invest in an Arbitrage fund through an intermediary or an AMC.

Benefits of Invest in Arbitrage Mutual Fund?

You may avail of the listed benefits by investing in these funds- 

(i)             Lower Risks

Arbitrage funds typically have a minimal amount of risk for the investor. Because each security is bought and sold at the same time, there is essentially no risk associated with longer-term investments. Arbitrage funds may also invest a portion of their capital in debt instruments, which are generally seen as fairly stable.

When there is a scarcity of attractive arbitrage deals, funds increase their debt exposure. This makes this form of investment particularly enticing to investors who have a low-risk tolerance.

(ii)            Taxation

Although such funds generally invest in equities, they are technically balanced or hybrid funds because they invest in both debt and equity. As a result, they are taxed as equity funds because long equity accounts for at least 65% of the portfolio on average.

Taxation Rules of Arbitrage Mutual Funds : For taxation purposes, Arbitrage funds are treated similarly to equity funds with the following tax rules:

• Short-Term Capital Gains (STCG) are taxed at 15%
• Long-Term Capital Gains (LTCG) are taxed at 10% without indexation