Arbitrage funds offer investors the opportunity to earn market-beating returns through a low-risk investment strategy. They are a type of hybrid mutual fund in India that exploits price discrepancies between the same security traded in different markets. These funds identify and exploit price differences between two markets or securities to generate returns.
Read on to learn how these funds work, who should consider investing in them, and their key features.
How do arbitrage funds work?
Arbitrage involves taking advantage of price discrepancies between two markets for the same security. Arbitrage funds utilise this strategy by simultaneously buying and selling securities in the cash and futures markets.
Here’s how it works:
- Identify price discrepancy: The fund manager identifies a security whose price is lower in the cash market than its futures contract price.
- Buy in cash market: The fund buys the security at a lower price in the cash market.
- Sell in the futures market: Simultaneously, the fund sells a futures contract to sell the same security at a higher price in the future.
- Profit from convergence: As the future contract nears expiry, the security price in both markets converges. The fund manager then sells the security in the cash market at a higher price, locking in a profit.
This strategy provides a relatively risk-free opportunity to earn returns, as the price difference usually converges before the expiry of the futures contract.
Who should invest in arbitrage funds?
Arbitrage funds are ideal for investors with the following profile:
- Retirees seek stable returns to supplement income without depleting their principal investment amount. Arbitrage funds provide relatively low volatility and consistent returns.
- Consumers hope to accumulate wealth over the long run. The compounding effect of regular, inflation-beating returns can build substantial capital over decades of investing in arbitrage funds.
- Savers who want their money to work harder than a normal savings account. Arbitrage funds typically provide higher returns than savings accounts while maintaining high liquidity and low risk.
- Investors are seeking diversification in their portfolios. Arbitrage funds have a low correlation with equity fund and debt fund markets, so adding them to an investment portfolio can help reduce overall volatility and risk.
Key features of arbitrage funds
Low volatility: Arbitrage funds are known for their low volatility, making them suitable for conservative investors.
Stable returns: Though returns are not guaranteed, arbitrage funds typically offer consistent and stable returns.
High liquidity: These funds are highly liquid, allowing investors to redeem their online investments when needed quickly.
Tax efficiency: Arbitrage funds are taxed as debt funds, offering tax benefits compared to equity funds.
Low entry barrier: Most arbitrage funds have low minimum investment requirements, making them accessible to investors with varying budgets.
Bottom line
Arbitrage funds aim to generate returns through price differences in the equity and derivative markets. Understanding these funds and carefully choosing the right one based on your individual needs can help you reap the benefits of this investment strategy.
