Arbitrage Mutual Funds: Should Invest in these best Mutual Funds in 2020

• 10 August 2020 | 1410 Views | By Mint2Save

While mutual funds are known to be of various types, arbitrage mutual funds are on a different horizon, when compared with equity or debt. Taking advantage of the market price imperfections or differentials, arbitrage mutual funds bet on volatility. In this article, we shall explore basics, concept, safety, and other interesting dimensions of arbitrage mutual funds.

What is the concept of arbitrage?

Arbitrage is basically a process of continuous buying and selling of securities, currency, or commodities in different markets or in derivative forms so as to take advantage of differing prices for the same asset. This concept is implemented for funds. An arbitrage fund is a category of equity mutual fund that holds an upper hand on the price differential in the cash and derivatives market to generate returns.

The fund manager simultaneously buys shares in the cash segment and sells them in the derivatives segment of the same company as long as the futures are trading at a reasonable premium. The scheme does not take a naked exposure to any individual company or an index as each buy transaction in the cash market has a corresponding sell transaction in the futures market.

How does arbitrage mutual funds work? 

Arbitrage funds work by exploiting the price differential between assets of various types that theoretically have the same price. One of the most important types of arbitrage takes place between the cash and futures markets. A typical fund is purchased with the hope of selling them later after the price has gone up. 

What is hybrid arbitrage mutual fund?

The arbitrage funds are hybrid mutual funds that generate returns by using the principle of simultaneously buying and selling securities in different markets to take advantage of different prices. No stock market risk is involved as the buying and selling price of a stock is known to the fund manager doing it.

Is it safe to invest in Arbitrage Mutual Funds?

Investors can use arbitrage funds to earn some returns in the interim period who wait for a correction in the markets before committing long-term money to equity. The payoff for Arbitrage Funds can be unpredictable and could depend on the arbitrage opportunities in the market, however the risk is comparatively low.

The fund manager creates a market neutral position by buying in the cash market and selling in futures which places it at a relatively high rank in terms of safety. Higher the volatility, more are the opportunities of the Arbitrage funds. With corporate earnings yet to pick up and valuations in broader markets high, there could be increased volatility which can make it a good investment option.

How do I choose an arbitrage fund?

Arbitrage fund is considered as a low-risk and well-working fund in an unstable or volatile market. When there is a difference in the value of a share in the cash market/spot and future market/derivatives market, this price difference of the arbitrage funds act as an advantage after using the profit. The best arbitrage funds are brought from the cash market at a low price and sold in the future market for a higher price, and hence using the stock market volatility to the advantage of the investors. Greater the uncertainty and instability in the market, the greater is the profit for the investors. In an arbitrage fund, the fund manager earns profit for the investor by simultaneously buying shares in the cash market and selling it in the derivatives market. 

Are arbitrage funds better than liquid funds?

Liquid funds hold debt instruments while arbitrage funds invest in equity. Liquid funds aim to generate returns by accruing interest from underlying papers. They invest only in very short-term high-quality papers. Therefore, they have a very low credit risk and interest rate risk. Their holdings don’t see price volatility and this makes liquid fund returns stable. Barring exceptional circumstances, they don’t suffer losses even on a daily basis. This makes them an ideal option for temporarily investing surplus money. Unlike other equity funds, arbitrage funds are low-risk because of their strategy. Arbitrage, as a strategy, aims at taking advantage of mispricing between the cash and the futures market. Arbitrage funds hedge their entire stock holdings. Essentially, there is no market risk despite investing in equity. However, because of this hedging, they also don’t enjoy equity-like returns.

Which liquid fund is best? 

The best liquid funds are the ones that have the lowest risk associated with their interest rates. Some of the best liquid funds are mentioned below-

IDBI Liquid Fund

Franklin India Liquid Fund,

Quant Liquid Fund

Nippon India Liquid Fund

LIC MF Liquid Fund

Baroda Pioneer Liquid Fund

Tata Liquid Fund

Mahindra Liquid Fund

Who should invest in arbitrage funds? Is arbitrage risk-free? 

Considering the low-risk factor, the arbitrage funds are best suited for investors who want a substantial profit from volatile markets that cannot tolerate high risk. Arbitrage mutual funds benefit the ones with high net worth investors to invest their money for a short tenure, since the advantages over debt mutual funds comes from taxation. The irony is that the arbitrage funds’ risk level is similar to a pure debt fund. Investors with short to medium-term financial goals choose arbitrage funds. 

Talking about the risk, trades happen over the stock exchange, hence the investors do not have to worry about the counterparty risk involved.

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Why are arbitrage mutual funds becoming attractive? 

Arbitrage mutual funds are considered an alternative to short-term investment options such as liquid and ultra-short-duration funds making it quite an attractive option for the investors. The returns generated by arbitrage funds depend on the volatility in the equity market and the prevailing short-term rates in the money market makes it a better option. Besides, tax-efficiency makes arbitrage funds a superior option to liquid and other short-term debt funds. Arbitrage funds are well-suited for investors in the 20 percent or 30 percent tax bracket looking for a safe investment upto 1 year.

Can arbitrage funds give negative returns?

Arbitrage funds can give negative returns in the very short term. Calculation considering various aspects, based on the NAVs over the past five years shows these funds generated negative returns for a holding period of up to 45 days.

How are arbitrage funds taxed? 

The tax for arbitrage funds and equity funds are equal, as they invest mostly in inequities. This equity-based fund has more tax advantages which makes it a good option during volatile conditions in the stock market. For investors within a tax bracket of 20 percent or 30 percent, arbitrage funds are the best mutual funds since they provide a safe passage for the money.

The returns earned by holding the best arbitrage funds for more than a year are tax-free called long-term capital gains (LTCG). In the first year, a 15% tax is levied on income from these funds which is known as a short-term capital gain (STCG). There is no dividend distribution tax on these funds, however, when the stock market is unstable, rich dividends can be gained with such funds. Although, the best performing arbitrage mutual funds are not suitable for short-term investors. So in order to gain tax benefits, one needs to hold it for about one year. 

When should you invest in arbitrage?

Investors can invest in arbitrage funds to earn some returns in the interim period who wait for a correction in the markets before committing long-term money to equity.