Investors are always on the lookout for opportunities that balance risk and return. Arbitrage funds have gained popularity as a low-risk investment option, particularly among conservative investors. But what exactly are arbitrage funds, and how do they work? Are they the right choice for you?
In this article, we’ll break down everything you need to know about arbitrage funds, including how they function, their advantages, risks, taxation, and key considerations before investing.
What Are Arbitrage Funds?
Arbitrage funds are hybrid mutual funds that capitalize on price differences in different markets to generate returns. They primarily buy stocks in the cash market and simultaneously sell them in the derivatives market, profiting from market inefficiencies.
Since these funds rely on market volatility, they perform well when there are frequent price fluctuations. However, in stable markets, returns may be lower compared to equity funds.
How Do Arbitrage Funds Work?
Arbitrage funds exploit mispricing opportunities in securities. Here’s a simple breakdown:
- Identifying Price Gaps – A stock trades at ₹500 in the cash market but at ₹510 in the futures market.
- Buying Low, Selling High – The fund manager buys the stock in the cash market and sells it in the futures market.
- Booking Profit – When both positions are squared off, the ₹10 per stock difference becomes the profit.
Since these transactions are risk-free (due to simultaneous buying and selling), arbitrage funds are considered a safe investment, especially during volatile market conditions.
Key Features of Arbitrage Funds
1. Low-Risk Investment
Since arbitrage funds take advantage of price discrepancies, they carry lower risk compared to pure equity funds.
2. Tax Efficiency
Arbitrage funds are taxed like equity funds, making them more tax-efficient than debt funds. If held for over a year, the gains are taxed at 10% (long-term capital gains) beyond ₹1 lakh. Short-term capital gains (less than one year) are taxed at 15%.
3. Best Suited for Volatile Markets
The more fluctuations in stock prices, the better arbitrage funds perform. During stable market conditions, returns can be lower.
4. Returns Comparable to Liquid Funds
On average, arbitrage funds offer returns in the range of 4-6% per annum, making them a viable alternative to liquid and short-term debt funds.
5. Lock-in Period and Liquidity
Unlike Fixed Deposits (FDs) or ELSS funds, arbitrage funds do not have a lock-in period. However, most funds have an exit load if redeemed within 30-90 days.
Who Should Invest in Arbitrage Funds?
- Conservative Investors: Those looking for safer alternatives to equity investments.
- Short-Term Investors: Individuals seeking stable, tax-efficient returns for 6 months to 1 year.
- Tax-Savvy Investors: Those who want to save on taxes compared to traditional debt funds.
- Investors in Volatile Markets: If the stock market is experiencing frequent fluctuations, arbitrage funds can generate good returns.
Risks and Limitations of Arbitrage Funds
While arbitrage funds are considered low-risk, they still have some downsides:
- Lower Returns in Stable Markets – If price differences between cash and derivative markets shrink, profits are minimal.
- Liquidity Constraints – Redemption within a short period might attract exit loads.
- Dependence on Market Volatility – Unlike other funds, arbitrage funds thrive on market fluctuations.
How to Choose the Right Arbitrage Fund?
Before investing in an arbitrage fund, consider these factors:
✅ Expense Ratio – A lower expense ratio means higher net returns.
✅ Historical Performance – Compare past returns of different arbitrage funds.
✅ Exit Load – Check the period within which withdrawal attracts a penalty.
✅ Fund Manager Expertise – A skilled fund manager can identify better arbitrage opportunities.
✅ AUM (Assets Under Management) – Larger AUM usually indicates better management and trustworthiness.
Frequently Asked Questions (FAQs)
1. Are arbitrage funds completely risk-free?
No, but they are considered low-risk as they hedge market movements through simultaneous buying and selling.
2. Can arbitrage funds provide better returns than FDs?
Yes, arbitrage funds often outperform Fixed Deposits, especially due to their tax benefits.
3. How long should I stay invested in an arbitrage fund?
Ideally, for at least 6 months to 1 year to maximize returns and avoid exit loads.
4. Do arbitrage funds work in a bear market?
They can, but profits are lower in stable or bearish markets. These funds work best during market volatility.
5. Is SIP a good option for arbitrage funds?
Yes, Systematic Investment Plans (SIPs) in arbitrage funds can help generate steady returns over time.
Conclusion
Arbitrage funds are a great investment option for those seeking low-risk, tax-efficient, and stable returns. They thrive in volatile markets and offer an excellent alternative to debt funds or liquid funds.
If you are a conservative investor looking for predictable yet profitable investments, arbitrage funds might be the perfect fit for you. Before investing, always compare different funds, check the expense ratio, and consider market conditions to make an informed decision.