Arbitrage funds are a type of mutual fund, which aims to earn returns by taking advantage of price differences in financial markets.
Unlike other equity schemes, these funds adopt a market neutral strategy to reduce risk and make gains from mispricing. For e.g. they may buy and sell two related securities to profit from differential pricing.
Knowing the functioning of arbitrage funds is key for investors wanting to diversify their portfolios and earn stable returns.
In this article, we look at what arbitrage funds are, how they work, and how they generate returns helping you decide on investments better.
What are Arbitrage Funds?
Arbitrage funds are a type of hybrid mutual fund that employs a distinctive investment strategy to generate returns. To invest in MF, you need to know that these funds aim to profit from price differentials of the same asset traded in different markets, primarily the cash and futures markets.
Arbitrage involves buying an asset in one market while simultaneously selling a similar asset in another market to exploit the price difference and achieve a risk-free profit.
For arbitrage funds, this strategy focuses on capitalizing on pricing inefficiencies between cash market securities and their corresponding futures or other eligible securities.
How Does an Arbitrage Mutual Fund Work?
Imagine the equity share of company ABC is trading at ₹1,220 in the cash market and ₹1,235 in the futures market. The fund manager buys ABC shares from the cash market at ₹1,220 and simultaneously sells a futures contract to sell them at ₹1,235. By the end of the month, when the prices align, the manager sells the shares in the futures market, earning a risk-free profit of ₹15 per share, minus transaction costs.
Alternatively, if the manager expects the price to drop, they may short-sell shares in the cash market at ₹1,235 and buy them back in the futures market at ₹1,220, making a ₹15 profit.
In another scenario, the manager could purchase a share for ₹100 on the National Stock Exchange (NSE) and sell it for ₹120 on the Bombay Stock Exchange (BSE), securing a risk-free return.
Benefits of Investing in Arbitrage Funds
Arbitrage funds offer several benefits, making them an attractive option for investors seeking low-risk returns. Some key advantages include:
1. Low-Risk Investment
Arbitrage funds are considered low-risk because they take advantage of price differences in stocks across various markets.
They buy a stock in one market where the price is lower and sell it in another where the price is higher, locking in a profit. This process doesn’t rely on stock market direction, reducing the impact of market volatility.
Since profits come from the price gap rather than market trends, arbitrage funds are generally less risky compared to pure equity investments.
2. Stable Returns
Arbitrage funds use strategies that take advantage of price differences in various markets, which helps reduce the impact of market volatility.
Even when the market experiences sharp ups and downs, these funds aim to generate consistent returns through hedging. This approach makes them less dependent on overall market movements and helps shield investors from large losses.
For those seeking a more secure option in uncertain times, arbitrage funds are often seen as a reliable choice for steady gains.
3. Liquidity
In volatile markets, arbitrage funds help reduce risk using a strategy that takes advantage of price differences in stocks across different markets.
This approach provides more consistent returns compared to regular equity funds, even when the market fluctuates.
Investors benefit from lower exposure to market risk, which helps keep returns steady and predictable, making arbitrage funds a reliable option during times of uncertainty.
Conclusion
Arbitrage funds offer a smart way to invest with lower risk while taking advantage of market price differences. They can provide stable returns, making them a good choice for conservative investors who want to avoid high volatility. However, it’s important to understand the risks and have a clear investment strategy before investing in any fund.