Arbitrage funds are another variant of mutual funds but are taxed like equity funds. In Arbitrage funds, the payoffs are unpredictable, even though they are relatively low-risk funds.
An arbitrage fund purchases stock in the cash market and simultaneously sells that interest in the futures market.
S. Ravi, Former Chairman of Bombay Stock Exchange, Founder and Managing Partner of Ravi Rajan & Co. says, “They function by exploiting the price differential between assets that should theoretically have the same price. The differences between stock prices and futures contracts are usually small. Arbitrage funds must execute a large number of trades each year to make any substantial gains.”
What are Arbitrage funds?
The cash market price of a stock also called the spot price, industry experts say is what most people think of like the stock market. For example, suppose that the cash price of a share is at the prevailing market price, then one can purchase a share for its value and own that portion of the company when the trade is executed. A company’s share might sell at 20 per share today, but perhaps the majority of investors feel the company is primed for a spike next month. In that case, a futures contract with a maturity date one month down the road may be valued much more highly. The difference between the cash and futures price for ABC stock is called the arbitrage profit. Arbitrage funds take advantage of these different prices. They buy stock in the cash market and simultaneously sell a contract for it on the futures market if the market is bullish on the stock.
Ravi adds, “If the market is bearish, then arbitrage funds purchase the lower-priced futures contracts and sell shares on the cash market for the higher current price. Arbitrage funds may also profit from trading stocks on different exchanges. They could be bought on one stock exchange at a certain price and sold on another exchange at a higher price.”
Benefits of Arbitrage funds
Arbitrage funds offer multiples benefits – Experts say these include firstly, low risk because each security is bought and sold simultaneously; there is virtually none of the risk involved with longer-term investments. Arbitrage funds also invest part of their capital into debt securities, which are typically considered highly stable. If there is a shortage of profitable arbitrage trades, the fund invests more heavily in debt. That makes this type of fund very appealing to investors with low-risk tolerance.
Ravi says, “Another significant advantage to arbitrage funds is that they are some of the only low-risk securities that flourish when the market is highly volatile. That is because volatility leads to uncertainty among investors. The differential between the cash and futures markets increases when prices are unstable. A highly stable market means individual stock prices are not exhibiting much change. When markets are calm, investors have no reason to believe stock prices one month in the future will be much different from the current prices. Volatility and risk go hand in hand.”
Who should invest in Arbitrage funds?
Industry experts say arbitrage funds are a good choice for cautious investors who want to benefit from a volatile market without taking on too much risk. Secondly, they are taxed as Equity Funds.
Ravi says, “Arbitrage funds are technically balanced or hybrid funds because they invest in both debt and equity, but they invest primarily in equities. Therefore, they are taxed as equity funds since long equity represents an average of at least 65 per cent of the portfolio.”
Hence as an investor, if you hold your shares in an arbitrage fund for more than a year, then any gains that are received are taxed at the capital gains rate. This rate is much lower than the ordinary income tax rate.
He further adds, “Arbitrage funds are apt for those investors who are looking to have equity exposure but are worried about the risk associated with the same. Arbitrage funds are a safe option for risk-averse individuals to safely park their surplus funds when there is a persistent fluctuation in the market.”
Drawbacks of Arbitrage funds
One of the drawbacks of arbitrage funds is the unpredictable payoffs. Experts say, one of the primary disadvantages of arbitrage funds is their mediocre reliability. Ravi says, “Arbitrage funds are not very profitable during stable markets. If there are not enough profitable arbitrage trades available, the fund may essentially become a bond fund, albeit temporarily. Excessive time in bonds can drastically reduce the fund’s profitability, so actively managed equity funds tend to outperform arbitrage funds over the long term.”
Additionally, they have high expense ratios. The high number of trades required by successful arbitrage funds means their expense ratios can be quite high. Experts say, even though arbitrage funds can be a highly lucrative investment, especially during periods of increased volatility, their inadequate reliability and high expenses indicate that they should not be the only type of investment in a portfolio.