Mutual Funds’ Investments

Arbitrage Mutual Fund

Investing can be a daunting task, especially when looking for options that offer stability and low risk. Among the numerous choices available, Arbitrage Mutual Funds have emerged as an attractive investment vehicle for individuals looking to benefit from securities market with minimal risk. This article provides a comprehensive understanding of arbitrage mutual funds, covering their meaning, operation, features, benefits, and more, all in an easy-to-understand format.

What is an Arbitrage Mutual Fund?

An Arbitrage Mutual Fund is a type of mutual fund that seeks to generate returns by exploiting price differences in the cash market (spot market) and the derivatives market (futures market). These funds capitalize on temporary mismatches in prices across these markets to create risk-free profit opportunities.

These funds are classified under the equity-oriented mutual fund category as they primarily invest in equity and equity-related instruments.

How Does an Arbitrage Mutual Fund Work?

Arbitrage mutual funds function by taking advantage of price discrepancies between the cash and derivatives markets. Here’s how it works step-by-step:

  1. Identify Price Gaps The fund manager identifies a stock that has a price difference between the cash market and the futures market.

    • For example, if Stock ABC trades at ₹100 in the cash market and ₹102 in the futures market, there is a ₹2 price gap.

  2. Simultaneous Transactions:

    • The fund buys the stock in the cash market at ₹100.
    • Simultaneously, it sells the same stock in the futures market at ₹102.

  3. Profit Booking: On the contract's expiry date, the prices in the cash and futures markets converge, and the fund exits both positions, locking in the risk-free profit of ₹2 per stock.

  4. Deployment of Idle Funds: In times of fewer arbitrage opportunities, the fund may park idle funds in debt or money market instruments to ensure stable returns.

Features of Arbitrage Mutual Funds

A company may decide to buy back its shares for several reasons:

  1. Equity-Oriented: These funds invest heavily in equities but are less volatile compared to pure equity funds.

  2. Low-Risk Strategy: Instead of paying dividends, companies use extra cash to buy back shares.

  3. Tax Efficiency: By reducing public ownership, companies can protect themselves from external control

  4. Short-Term Investment: Promoters may use buyback to strengthen their stake in the company.

  5. Market-Dependent: Returns depend on market volatility and the availability of arbitrage opportunities.

Benefits of Arbitrage Mutual Funds:

  1. Low Risk, Equity-Like Returns: Since the buying and selling are hedged, the risk is minimal, making it an attractive option for risk-averse investors

  2. Tax Advantages: Gains from arbitrage funds held for more than one year qualify as long-term capital gains (LTCG).

  3. Liquidity: Arbitrage funds offer high liquidity, allowing investors to redeem their money quickly when needed.

  4. Diversified Portfolio: These funds diversify investments across various sectors and instruments, reducing the risk.

Limitations

  • Market Dependency: Returns are linked to market volatility; low volatility means fewer opportunities for arbitrage.

  • Short-Term Focus: They may not be ideal for long-term wealth creation