Arbitrage Funds: Meaning, benefits and limitations

When she began her career at a major global MNC at 24, Ashima had a few goals in mind – reaching a mid-senior level position over the next five years, building a corpus along the way, and using her savings to start her own research firm. While she knew how to ascend in her career, she was unsure about how to accumulate enough wealth to start her own firm before she turned 30. That’s when her mentor suggested that she consider investing in mutual funds to boost her savings. Ashima had heard that mutual funds are good investment vehicles for saving your money and achieving your goals. However, she did not know much more, so she did a bit of reading. She learnt that mutual funds are popular investment options wherein a number of investors pool in their funds and purchase units in the underlying scheme. The scheme’s corpus is managed by experienced and professional fund managers who strive to help investors enjoy the best returns. Mutual funds are considered less risky than the stock market, as these funds are helmed by expert managers who track the market and hedge against potential losses. Considering Ashima’s age and career graph, she could take on a significant amount of risk in the search for strong returns. However, since her time horizon for this particular goal was 5 years, she was advised to take lesser risk. In this scenario, she considered her options and decided to go with arbitrage funds.

What Are Arbitrage Funds?

Have you been confused about the meaning of arbitrage funds? Well, arbitrage funds make their profit by playing on price differentials in the market. For instance, your arbitrage fund may buy stocks in the cash market and earn a profit by simultaneously selling the same stocks in the futures market. Or they may try to earn returns by benefitting from the price difference between gold spot and gold futures. While the price difference may not be significant, arbitrage funds make profits by executing a large quantum of trades each year.

Arbitrage funds are different from normal mutual fund schemes wherein the fund managers buy stocks at a certain point in time, on the basis of a belief that the prices will rise at a later stage. When the prices are up, fund managers sell their stock to earn handsome returns. However, if the equity markets witness a prolonged fall, then the fund manager faces a high degree of risk. If this happens, the fund may lose value instead of generating returns. Arbitrage funds do not face this risk as they make their profit from volatile prices, thus making it a good investing opportunity for investors like Ashima.

Benefits of Arbitrage Funds

• The biggest benefit of investing in arbitrage funds is their low-risk nature. Since they purchase and sell each security simultaneously, they are able to lock-in a certain return. Further, arbitrage funds do not invest their entire corpus in equities – a portion is allocated to highly stable debt securities, thus lowering the risk further. You earn stable returns from the debt portion of the fund along with risk-free returns from arbitrage opportunities that exist in equity markets. This makes the fund appealing to investors with a low-risk appetite.
• The second benefit of arbitrage funds is that these instruments can help you earn a profit even when the markets are volatile. Usually, investors prefer to sit on the side-lines during volatile period but if you invest in arbitrage funds, the volatility will work in your favour.
• The third benefit of investing in arbitrage funds comes from the fact that it is taxed in line with equity funds.

Arbitrage funds have two major drawbacks – the returns can be unpredictable, and the expense ratio is high as these funds are actively managed by experienced professionals. However, if you are keen on investing in mutual funds but have a low-risk appetite, arbitrage funds can be a great option for you.

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