Arbitrage Fund: Meaning, Benefits & How it Works

Arbitrage funds have caught the attention of investors for three reasons. The first reason is the inflow of Rs. 3712 crores in arbitrage funds in April 2023, which was the highest amount of funds invested in this category between April 2022 to April 2023.The second reason for its recent popularity is also the reason why such large amounts are being invested in arbitrage funds. Arbitrage funds are now offering slightly better short-term returns than liquid funds, touching up to 7%. In contrast to liquid funds, arbitrage funds carry equity-linked tax benefits, which contributes to their better returns. This is the result of an improved sentiment towards the equity market, which creates a volatile market for arbitrage funds to take advantage of.The third reason can be attributed to the rise in interest rates by the RBI (Reserve Bank of India), which makes debt funds offer lower returns to investors. In such a scenario, there is a natural yet sudden shift towards the equity markets and investments poured into arbitrage funds to leverage the equity exposure and offer higher returns.However, it is prudent to note that just a year ago (2022), arbitrage funds offered lowered returns which resulted in a massive outflow from the category. From touching Rs 1.1 lakh crore last year, funds invested in arbitrage funds dropped to Rs. 82,242 crores in 2023. When Nifty’s PE (Price to Earnings Ratio) dropped from 28 to 18 in last one year, investors redeemed their arbitrage allocations and moved to equity since the dip in Nifty valuations meant a chance of the stock price to increase in the future.Arbitrage funds essential benefit from the difference in the cash prices and futures market prices. The higher the spread, the more the returns. However, this strategy needs to be well-thought out and should be backed by latest financial insights to leverage its benefits.This article will shed light on the importance of arbitrage funds and everything you need to know about investing in these funds so that you can make an informed financial decision which maximises your returns and keeps your investment portfolio well-balanced and hedged against uncertainty.

Arbitrage means buying and selling securities, derivatives, or currencies simultaneously from different markets. The aim is to make risk-free profits by buying it from a market offering a lower price and simultaneously selling it to another with a higher price. For example, if you buy a security at Rs. 100 from Market A and sell it simultaneously for Rs. 110 in Market B. This way you will make a profit of Rs. 10.Arbitrage funds are hybrid mutual fund schemes that invest in the same asset (equities as well as derivative instruments) in two market segments. For example, the arbitrage fund manager can buy an asset in the cash market and simultaneously sell it in the futures market at a higher price and book a profit. In the cash market, the transactions are settled on the spot. In the futures market, it is sold at a pre-determined price on a future date.According to SEBI (Securities and Exchange Board of India) , 65% of arbitrage funds should be invested in equities and equity-related securities. Apart from this, they can also invest in debt and debt-related securities.Remember that the fund manager invests in debt securities and short-term money market instruments only when an opportunity to leverage the spread is available. This requires careful analysis of the current market sentiment. Another thing to remember is that the difference in prices is moderate. The price difference or the profits made are slight, so the fund manager has to make many such transactions in a day to make a good amount of profit.

There are many ways in which a fund manager can take arbitrage positions. Arbitrage trading in India can be done in the following ways:

The price difference between two exchanges

The share price of a company might be different in two exchanges. The arbitrage fund manager takes an arbitrage position. This refers to an investment strategy mainly used for hedging where assets are bought at a lower price in one exchange and simultaneously sold in another exchange at a higher price. The profits are made from the spread available here.For example, the share price of a company XYZ is Rs. 3000 on BSE (Bombay Stock Exchange) and the same company's share price is Rs. 3025 on NSE (National Stock Exchange). Here the arbitrage fund manager will buy the shares on BSE and simultaneously sell them on NSE. This way a profit of Rs. 25 will be made per share.Alternatively, the fund manager can also take an arbitrage position in the two exchanges of different States. Read more here.

The price difference between two securities - Capital Structure Arbitrage

Fund managers also opt for capital structure arbitrage, which refers to a strategy of leveraging the mispricing across different financial instruments of a company to make profits. By buying the undervalued securities and selling overvalued securities of the same company, profits can be recorded. These are essentially short-term strategies only since the pricing difference will even out eventually.For example, let’s assume a company reported poor annual results leading to a significant drop in the stock market by 10% in the share price. At the same time, the company’s bond price will not fall immediately but will take a few days to eventually drop as well. Taking advantage of this, investors can sell the bond, which is currently an overvalued security and buy the stock of the company which is currently an undervalued security and profit from the capital structure arbitrage.

The price difference between cash and future market

Arbitrage between two market segments, the cash or spot market and the futures market, can occur. Arbitrary fund managers mostly use this strategy, and it is commonly known as ‘cash and carry’ arbitrage. In this, the shares of the same company are bought in one market and sold in the other. These transactions can take place between the cash market, and the futures and options market.For example, let’s assume a company named ABC Ltd's shares trade at Rs. 3,200 in the NSE (National Stock Exchange of India) cash market. It currently trades at Rs. 3,250 in the futures market. Here the arbitrage fund manager can buy the shares of this company at Rs. 3,200 in the cash market (also known as the spot market) and simultaneously sell it in future markets at Rs. 3,250. This would result in risk-free profit.Both prices will converge during expiry, which means the cash market price will move higher, and the future market price will be lower. The fund manager would make a profit of Rs. 50 per share.

The price difference in Index and Basket of Stocks

Arbitrage can also be made on indices like Nifty50, Nifty100, Nifty Bank etc. instead of an individual stock.For example, Nifty 50 Futures is trading at 18,150, and a basket of stocks with a similar proportion of stocks as the index is trading at 18,100 in the cash market. The fund manager can profit by taking a short position on Nifty50 Futures and buying the equivalent basket in the cash market at a lesser price. This way, a profit of 50 points can be made on Nifty trade.Apart from this, arbitrage trading can also be created by corporate actions or events such as: Mergers and acquisitions - An arbitrage strategy can be adopted when two firms or corporates merge. A share swap ratio is assigned to the company being acquired or merged which denotes the number of shares of the acquiring company that the shareholders of the acquired company will get.A share swap ratio of 1:20 means the shareholders of the acquired company will get 1 share of the acquiring company for every 20 shared they held in the acquired company. This could create a price disparity and a massive volatility in the share price of both these companies for a while before they stabilise. Depending upon the share swap ratio, the fund manager calls on which to buy and which to sell that would maximise the returns. Rights issue - when a company needs more funds, they issue shares to their existing investors. These shares are offered at discounted prices for a limited period. This can be arbitraged by buying at a discounted price and selling at market price. Buyback arbitrage - when a company buys back their shares, there may be a difference in the trade and buyback prices.

Arbitrage trading in India can be done on commodities also. The different types of arbitrage strategies used in commodity arbitrage trading are:

• Calendar spread When a trader buys and sells the future contract of a commodity at the same strike price. The expiry of the two future contacts is different. For example,
  A trader can buy a gold futures contract in February 2023 at Rs. 58,100. Simultaneously the trader sells a gold futures contract on March 2023 at Rs. 58,600. The contracts are made on the same day, but the expiry is different. The difference in the price is the profit made.
• Scalping/Jobbing Strategy This is a short-term trading strategy where several trades must be executed to make profits. The price movements are predicted by analysing the markets and the behaviour pattern of the existing buyers and sellers. Jobbing /scalping is only done when the transaction costs are low. These trades aim to make a quick profit in many trades; hence less risk is involved. The traders must constantly monitor the price movements.
• Trading based on Technical Charts and Tools The future prices of the commodities can be predicted by using technical analysis of the charts and available tools. This can help in predicting accurately and increasing returns.

• Gold and Silver
• Gold and Crude Oil
• Silver and Copper
• Soya Oil and Soyabean
• Zinc and Lead
• Mustard Oil and Mustard Seeds

• Cash and Carry Arbitrage Strategy This strategy involves buying and selling the commodities in different markets (spot and futures). The commodity traders set a trade in the spot market and simultaneously take a position in the future market. The profit here will be the price difference in the commodity in both markets. Example - Supposing in May 2023, the price of rice in the cash market is Rs. 2900 per quintal. In the futures market, the rice price for the June expiry contract is Rs. 2950 per quintal. Here the trader can buy the commodity(rice) in the spot market and simultaneously sell it In the future market. This way, a profit of Rs. 50 per quintal can be made.The actual profit will be after the deduction of any applicable charges.
• Future Spread Strategy In this strategy, only the future prices of the same commodity are traded, and the profit is the difference between the future contracts. In this, the movement of the spread is more important than the commodity's price movement. This strategy is quite risky, and the right decision needs to be made to make profits.The different trading strategies that can be used are:
• Inter-exchange strategy This happens when a commodity is traded in exchanges with the same expiry contract. The trader takes advantage of the price difference in two exchanges based on liquidity, volatility, and contract specifications. For example, the price of a commodity is Rs. 700 per 5 kgs in the Multi Commodity Exchange of India Limited (MCX). The same commodity price is Rs. 705 in National Commodity and Derivative Exchange (NCDEX). The trader buys it in the Multi Commodity Exchange of India Limited and sells it in National Commodity and Derivative Exchange. Here the trader makes a profit of Rs. 5 per 5 kgs.
• Inter-commodity Strategy This trading involves taking two positions in two different commodities. One position can be extended (bullish) and the other short (bearish). The purpose of this trade is to make money from two different commodities. If both commodities move in the same direction, the trader will make a loss. This can only happen if they both move in different directions and the trader can identify the right direction of the commodity. Some of the most prominent commodity pairs are -

Read more about how to leverage Arbitrage opportunities in commodities here.

Following are the benefits of arbitrage funds:

1. Low Risk:

Arbitrage funds come with a low level of risk for investors. Since securities are bought and sold simultaneously, there is minimal risk compared to longer-term investments. These funds also invest in stable debt securities, making them appealing to those who prefer lower risk.

2. Thrive During Volatile Markets:

Arbitrage funds are among the few low-risk investments that perform well during times of high market volatility. When prices are unstable, the difference between cash and futures markets increases. In calm markets, stock prices remain relatively stable, and these funds can benefit from such situations.

3. Suitable for Cautious Investors:

For cautious investors who want to benefit from market volatility without taking on excessive risk, arbitrage funds are a good option.

4. Tax Treatment like equity funds:

Despite primarily investing in equities, arbitrage funds are treated as equity funds for taxation purposes. If you hold shares for more than a year, any gains you receive are taxed at the lower capital gains rate, which is favorable compared to the ordinary income tax rate.

Following are the limitations of arbitrage funds:

1. Unpredictable Payoff:

One of the major drawbacks of arbitrage funds is their unpredictability in generating returns. They may not perform well during stable market conditions. If there aren't enough profitable arbitrage opportunities, the fund's performance could resemble that of a bond fund temporarily, leading to lower profits.

2. Lower Long-Term Returns:

Excessive exposure to bonds can significantly reduce the fund's overall profitability. As a result, actively managed equity funds often outperform arbitrage funds over the long term, making them less attractive for investors seeking higher returns.

3. High Expense Ratios:

Successful arbitrage funds need a large number of trades which can lead to high expense ratios. While these funds can be highly profitable during periods of market fluctuations, their significant expenses suggest that they should not be the sole investment in an investor's portfolio.

The fund manager's job is to make profit for investors over a medium period. They handle the risk of sudden market fluctuations by investing part of the funds in safer investment avenues. They ensure that the investments are made in high-quality debt securities to match the expected returns when there aren't many good profit-making opportunities.

Arbitrage funds are taxed like equity funds. Short-term gains are taxed at 15%, and long-term gains at 10% without indexing. So, if you are in a higher tax bracket, investing in an arbitrage fund might be better than a debt fund to save on taxes.

Arbitrage funds are ideal for those who want to invest in equities but are unwilling to take risks. It is better to invest in arbitrage funds, where a professional fund manager handles the accumulated corpus. This will help them earn good returns without taking any stress of the volatility in the markets. Investors need to plan their financial goals and must be aware of their investment objectives. Accordingly, they can allot funds in arbitrage mutual funds.The arbitrage funds provide steady returns in all market phases (volatile, bull, bear). A lot of arbitrage opportunities can arise in any market condition. For instance, in a bull phase, the price of the future is higher than the spot market. In the volatile market, the stock prices are mismatched. The arbitrage fund manager identifies the profitable arbitrage opportunity for their investors.

Investments and arbitrage trading in India can be through any mutual fund company, an AMC (Asset Management Company), or a stock broker dealing with mutual funds. Investors can invest in arbitrary funds after the New Fund Offering (NFO) is introduced in the market.The investment can be made by paying a lump sum or SIP (Systematic Investment Plan) . The investors are allotted units of the fund according to the amount invested. The Net Asset Value (NAV) of the units keep changing with the change in the price of the units. The NAV (Net Asset Value of the units of the arbitrage funds keep changing with the changes in the price of the securities. The profit or loss of the investor would depend on the difference between the value of the units at the time of buying and selling them.Also read: Working Of A Systematic Investment Plan

When investors invest in arbitrage funds , they are appointed a fund manager by the mutual fund agency or the Asset Management Company. It is the fund manager's responsibility to ensure the investor's money is invested correctly and to make profits for the investor. A transactional fee is charged for the services rendered.Also read: Asset Manager or Fund Manager

The fund manager gathers the funds from various investors and invests this accumulated corpus in different investment schemes. Most funds are invested in fixed-income securities and debt funds with high credit quality. This investment helps in earning regular returns. A significant chunk of the funds is invested directly in the markets. The fund manager identifies the opportunities to arbitrage the investments . The arbitrage process in capital structure can be in two exchanges or different segments of the same market.

An investor must remember a few things before investing in arbitrary funds. Some of them are as follows:

• Risk factor There is no equity exposure risk since the arbitrage trade in India happens simultaneously in cash and the future market. There is no counter-party risk since they are traded in the stock market. However, there are few opportunities to conduct these trades. The price difference is also less, meaning the returns would be average.However, one must remember that there is no assurance of returns in arbitrage funds . Volatility plays a crucial role in these funds, and money can be made as long the markets keep moving in different directions. The opportunities are available when the market trade flat. If it continues, then the arbitrage funds will give below-average returns. Arbitrage funds are Hybrid funds which invest in short-term debts or term deposits. This would mean low returns with some interest rates and credit risk.
• Cost of investment Mutual fund companies, Asset Management Companies or stock brokers dealing with arbitrage funds charge an annual fee called an expense ratio. This is the percentage of the fund's total assets. This fee includes the fund manager's fees and the charges imposed by fund management. These are transaction costs which are charged on each trade.In addition to these charges, the fund houses levy exit loads for those selling their holdings within 30 to 60 days. These additional charges are imposed to stop their investors from exiting early.
• Returns Investors can earn moderate profits from their investments in arbitrage funds. Historically, if investor remains invested in these funds for one to six months, then returns of around 7% can be expected .Returns would depend a lot upon the fund manager’s strategies. It would depend upon how the fund manager would leverage the opportunities. Steady returns can be achieved in all phases - bull, bear and volatile. The arbitrage fund manager must identify these phases and invest accordingly. For instance, in a bull phase, the cash is priced lesser than the Futures. It is the opposite in the bear phase. In a volatile phase, the prices of the shares are mis-priced.
• Tenure of the Investment The ideal tenure for such funds would be a medium-term investment between 3 to 5 years. Exit load is charged for those investing only for 30 to 60 days. Those having a time frame of at least 6 months or above can invest in arbitrage funds. Since these funds depend greatly on volatility, the investor may invest in a lump sum instead of a SIP (Systematic Investment Plan). The investor may also consider investing when markets are highly volatile and showing no signs of a particular direction. If markets are not volatile, liquid funds will give better returns to the investor.
• Financial targets or goals These funds are suitable for those who have funds lying idle in their savings accounts and are willing to invest them for a few months to a few years. One must understand that these funds have small returns, but the risk involved is less. Few investments in equities and few in arbitrary funds would help them efficiently meet their financial targets. The investor may diversify the portfolio to meet the financial goals.

Regarding taxation, arbitrage funds are taxed in the same manner as equity funds. This is because the fund managers invest some funds in equities and debt. The taxation till 65% equity exposure is the same as equity funds.The taxes are applicable based on the holding period of the arbitrage funds . They are:

1. Short-term capital gains (STCG) taxes: This tax applies to the arbitrage mutual fund units sold in less than a year. The taxes imposed are at 15%.
2. Long-term capital gains (LTCG) taxes: This tax applies to an investor's arbitrage mutual fund units for over a year. A 1 lakh exemption is given on long-term capital gains in a financial year. Anything above 1 lakh in a financial year will be taxed 10% without indexation benefits. If a person falls in the higher tax-paying bracket, investments are made in arbitrage funds rather than debt funds.

This is because, from April 01, 2023, the taxation on debt mutual funds has been changed, removing all the benefits of long-term capital gains form debt-based investments (with less than 35% invested in equities). Short-term and long-term gains on debt mutual funds are now taxed as per the slab rate of income tax.However, this change is only for investments made on or after April 01, 2023. Therefore, if you invest in debt mutual funds, your returns after adjusting for tax will be lower. Link Read more about the tax implications of investing in arbitrage funds here.

Investment decisions should be made on the basis of financial goals and the resources available for investment. Factors like your risk appetite, the tenure you want to invest for, and the returns you are seeking play a major role in deciding the investment plan that is best suited for you. Whether arbitrage funds should form a part of your portfolio will depend on these factors. However, here is how arbitrage funds may perform in certain situations as compared to other traditional forms of investments to give you further insights into how arbitrage funds function.

Arbitrage funds as Compared to Fixed Deposits

Investors have their ways of investing to secure their future. Many are comfortable investing in fixed deposits. While there are others, who want more returns. For this, they invest in equities and debt funds. Here are some differences between the fixed deposit and arbitrage fund investments:

• Risk factor: The risk involved in investing in an arbitrage fund is more significant than fixed deposit investments.
• Liquidity: Arbitrage funds are highly liquid and give higher returns, whereas fixed deposits have less liquidity and lower returns. Returns: The fixed deposits give assured returns pre-determined at the time of investment. On the other hand, there are no guaranteed returns on arbitrage funds since they are linked to the stock market.
• Premature Withdrawal: Fixed deposits have a fixed tenure and a lock-in period. Any withdrawals before this maturity period will attract a penalty. On the other hand, if arbitrage funds are invested for a short time, then an exit load fee is charged. There are no additional charges for long-term investment in arbitrage funds.
• TDS (Tax Deducted at Source): Fixed deposits deduct TDS (Tax Deducted at Source) at 10 % if the interest income earned from the fixed deposit is more than Rs. 40,000. There is no TDS (Tax Deducted at Source) in arbitrage funds.
• Taxation: In fixed deposits, the interest income is added to an individual's income, and the tax to be paid is according to the income tax slab rate. On the other hand, in arbitrage funds, the Short-term capital gains (STCG) taxes are 15% if held for less than a year. Long-term capital gains (LTCG) taxes are 10% above Rs. 1 lakh if held for over a year.

Arbitrage funds as Compared to Liquid Funds /Debt funds

• Returns: Arbitrage funds are chosen by investors because of good returns in a very short period like six months to two years. However, if an investor wants more stable returns in the short term, then liquid funds are preferred by most investors. In the long term, they both deliver similar returns.
• Liquidity: Liquid funds are better in terms of liquidity. The money can be withdrawn from liquid funds in a day or two. Whereas arbitrary funds require three to five days to withdraw funds. Liquid funds can be redeemed after seven days without any exit fees. This is not the case with arbitrary funds.
• Expense ratio: Arbitrage funds have a higher expense ratio than liquid funds. This is because arbitrary funds need daily trading and arbitrary opportunities to make a profit. It is also dependent on the skills and efficiency of the fund manager. All this increases the cost of the fund considerably.
• Risk: The arbitrage funds are considered to be low-risk funds. Yet, when compared to the liquid funds they are slightly riskier than the liquid funds.
• Taxation: Arbitrage funds are more tax efficient than liquid funds. The gains in liquid funds are added to the taxable income in a financial year and taxed according to the income tax slab rate. Arbitrage funds are taxed at 15% in the case of STCG and 10% LTCG if held for more than a year with an exemption of Rs. one lakh in a financial year.

Arbitrage funds as Compared to Equity Funds

• Risk: Arbitrage funds are less risky than equity funds. A person with a high-risk appetite can invest in an equity fund. While those unwilling to take risks can consider arbitrage funds.
• Expense ratio: A rbitrage funds need to do daily trades. This increases the cost, which is eventually borne by the investor. Apart from this, an exit load (a fee levied on early exit) is also charged in case of exiting from the arbitrary fund thirty to sixty days after purchase. On the other hand, the expense ratio of the equity fund is low. The exit load in most of the equity funds is if exited within twelve months. This again depends upon the scheme in which the investor has invested.
• Returns: E quity funds deliver better returns than arbitrage funds. This is because of the equity holdings. In arbitrary funds, if there is a low arbitrage opportunity the returns might not be good.
• Taxation: Both these funds are taxed in a similar manner. However, a person falling in a higher tax bracket can opt for a short-term arbitrage fund. If the investor wants to invest for a period of one to three years, then equity funds could be a good option.

Arbitrage mutual funds are one of the few funds that have the potential of giving profits in a volatile market. Usually, in most other mutual fund schemes, the unit price falls whenever markets are volatile or less favourable. The unique strategy and tax benefits of arbitrage funds offers a good opportunity for investors to include this form of investment and try to hedge their portfolios against uncertainty in a volatile market. If you are thinking of investing in arbitrage funds, be sure to stay up to date with the latest news, understand the marketing triggers and invest in the arbitrage funds that suit your financial goals the most. Here is a summarised read that might interest potential investors of arbitrage funds.