Want to earn risk-free profits from market fluctuations? Arbitrage funds are often used by investors who want stable results with little risk. These funds take advantage of the market’s short-term price differences, making them a suitable choice when unstable. Arbitrage funds buy and sell assets at different prices simultaneously to make money without taking risks.
Let’s look at how these funds work, their benefits, and their risks.
What Is an Arbitrage Fund?
An arbitrage fund is a mixed mutual fund that invests in stocks and takes advantage of price differences in the market. These funds make money by buying stocks in one market at a lower price and selling them in another market for a higher price. This approach eliminates directional market risk, which keeps returns steady. If there are no arbitrage opportunities, the fund manager will put money into short-term debt instruments to get the best returns.
Arbitrage funds have the following characteristics:
- Market-Neutral Strategy: Price gaps, not market trends, are what make money.
- Equity-Oriented: At least 65% of the portfolio should consist of stocks and other instruments tied to stocks.
- An approach that Manages Risk: All investments are managed to lower risks.
- Short-Term Holding Period: Depending on the market, most positions last between a few days and a few weeks.
- Tax-Friendly: Gains are taxed like stock funds, making them better for taxes than debt funds.
How Do Arbitrage Funds Differ from Mutual Funds?
Arbitrage funds differ from regular mutual funds in several key ways:
- Low Risk: These funds involve minimal market risk because each trade is hedged by buying and selling the same security in different markets to capture price differences.
- Steady Returns: They typically offer modest but consistent returns, making them suitable for conservative investors.
- Ideal for Volatile Markets: Arbitrage opportunities increase when markets are volatile, allowing the fund to stay profitable even during price fluctuations.
- Tax Benefits: Since they are classified as equity funds, long-term capital gains (LTCG) enjoy favourable tax treatment.
- High Liquidity: Investors can usually redeem their units more easily compared to some fixed-income investments.
How Do Arbitrage Funds Work?
Here’s how arbitrage funds work:
- Finding Price Gaps: Fund managers examine currencies, stocks, or commodities to determine price differences between exchanges or market groups.
- Buying and selling simultaneously: The fund gets an asset at a lower price in one market or segment and sells it at a higher price in a different market or segment.
- Locking in Profits: The difference between the buy and sell prices is locked in, so gains are guaranteed no matter how the market goes.
- Continuous Monitoring: Market conditions are monitored in real-time so that trades can be adjusted to achieve the best results.
- The Earnings Generation: Capital gains, earnings, and interest income are the primary sources of returns.
An Example of An Arbitrage Trade:
- On the BSE, a stock costs ₹1,010, and on the NSE, it costs ₹1,000.
- To keep it at ₹10 per share, the fund buys the stock on the NSE and sells it on the BSE.
- When the price difference is fixed, the trade is over, and risk-free returns are secured.
Advantages of Arbitrage Funds
Arbitrage funds are a good way to invest because they have these pros:
| Low-risk Approach | Unlike equity funds, arbitrage funds try to minimise risk by simultaneously holding long and short options. |
| Great for Volatile Markets | Price differences become more prominent when the market changes, making arbitrage opportunities more common and raising returns. |
| Efficiency Tax | Arbitrage funds gain from equity taxation because they mostly invest in stocks:Gains made in the last year or less are taxed at 15%.Gains that last longer than a year up to ₹1 lakh without taxes, then 10% tax. |
| Diversifying your Portfolio | Adding arbitrage funds to a portfolio lowers the overall risk because they don’t follow stock market trends. |
| Better Returns than Debt | Arbitrage funds can give you better returns after taxes than fixed deposits or liquid funds. |
| Liquidity and Adaptability | There is no lock-in time (though some exit loads may be limited). It’s easy to cash so you can get your money quickly. |
Taxing Arbitrage Funds
Before buying, you should think about taxation on arbitrage funds:
- Short-term capital gains tax (STCG): Gains are taxed at 15% if held for one year or less.
- Long-term capital gains tax (LTCG): Gains up to ₹1 lakh are tax-free if kept for more than a year. Gains above that amount are taxed at 10%.
Arbitrage Funds Risks
Even though investing in arbitrage funds is a smaller risk, some things could go wrong:
| Risks | Details |
| Arbitrage Opportunities Limited | When market volatility is low, there are fewer chances for arbitrage, which means that returns are smaller. |
| Delays in Execution | For arbitrage to work, trades must be carried out quickly. Holdups can cut into earnings. |
| Risks of Market Liquidity | Some assets may not be very liquid, making it hard to get out of deals quickly. |
| Effects of Changes to Regulations | Changes to trade rules or tax laws can affect how profitable arbitrage is. |
| More Competition | Companies may make less money in the long run as more investors use arbitrage tactics. |
Secure Gains with Stability
Arbitrage funds are a good way to trade for people who want good returns with little risk and no taxes. They do well in markets that aren’t stable, so buyers can feel safe in them when things aren’t clear.
However, their success rests on how the market is doing and how good the fund managers are at what they do. Investing in arbitrage trading could also be a great way to diversify your portfolio and add low-risk, market-neutral investments.
One great thing about arbitrage funds is that they can make money without taking any risks. This makes them an excellent choice for buyers who want to be safe.
