What are arbitrage opportunities?

In two different markets, when there’s a difference in the price of the same security/currency/commodity, it gives rise to what is defined as ‘arbitrage opportunities’. In simple words, you can gain or profit from the price differential by taking counter positions of the same security/currency/commodity in two different markets simultaneously.

Thus, arbitrage transactions are virtually risk-free.

What are the two different markets?

The cash market is where investors buy securities to receive delivery of security and settle the trade by immediately paying for their purchase.

In the futures market, there isn’t immediate delivery of security. Instead, the contract you enter is to buy/sell the security at a future date.

For example, you see the stock of Bajaj Finance trading at Rs 2,581 in the cash market and at Rs 2,602 in the futures market. In such a case, if you bought 500 shares in the cash market, which is equivalent to one lot for Bajaj Finance in the future market, you could simultaneously sell this lot in the futures market. The difference of Rs 21 is your gross profit from the transaction. Your net profit depends on the costs you incur. However, these are short-term opportunities that spring up either due to demand-supply mismatches in different markets or due to the lack of information available to a set of market participants in one of the markets.

This is how arbitrage funds work… 

Arbitrage funds are categorised as equity-oriented schemes that take advantage of arbitrage opportunities present in all the segments of equity markets.

The fund manager of the arbitrage fund will evaluate the difference between the price of a stock in the futures market and in the spot market. If the price of a stock in the futures market is higher than in the spot market, after adjusting the costs and taxes, the fund manager will buy the stock in the spot market and sell the same stock in equal quantity in the futures market, simultaneously.

They usually invest in the cash market and sell in the future market. For this reason, arbitrage funds work well during the bull market phases, like any other equity-oriented fund. Arbitrage opportunities dry out under sideways market conditions, which is when the prices are range-bound, or during bear market phases when prices are usually moving down. 

In the sideways markets, the spread i.e. the differential between the cash market and derivatives markets aren’t attractive enough for fund managers to take advantage of arbitrage opportunities.

And in the bear market phases, future market prices trade at a discount to cash market prices. As a result, arbitrage funds get fewer arbitrage opportunities.

When there aren’t many arbitrage opportunities, arbitrage funds invest a sizable corpus in short-term debt and money market instruments.

Arbitrage Funds V/s. Short-term Debt Funds

	Absolute (%)		CAGR (%)
	6 Months	1 Year	2 Years	3 Years	5 Years
Average returns generated by arbitrage funds	3.1	6.2	6.4	6.6	7.5
Average returns generated by short-term debt funds	5.1	5.1	6.7	7.5	8.5

Note: The performance of only direct plans is considered
Data as on September 17, 2018
(Source: ACE MF, PersonalFN Research)

Taxation…

An arbitrage fund is mandated to follow arbitrage strategy and invest minimum 65% of its total assets in equity & equity related instruments. Thus, arbitrage funds are classified as the equity funds from a taxation angle.

Short-Term Capital Gains (i.e. realised profits within a year) on arbitrage funds are taxed at 15%, while Long-Term Capital Gains (i.e. gains made after staying invested for more than a year), are taxed at 10% for gains in excess of Rs 1 lakh in a financial year.

On the other hand, Short-Term Capital Gains (STCG) earned via short-term debt funds are taxed at the applicable rate as per your tax slab. Long-Term Capital Gains, i.e. gains made after staying invested for more than three years in case of debt mutual funds are taxed at 20% after opting for the indexation benefit.

Therefore, on the taxation front, arbitrage funds work better for investors with a time horizon of less than three years.

Let’s look at the advantages of arbitrage funds …

1. Since the buying and selling of the same asset happens simultaneously, returns of these funds are highly predictable as compared to equity-oriented mutual funds

2. The risk involved is minimal

3. Ideal for parking money for the short-to-medium term—say for one to two years

4. A good alternative to keeping money idle in the savings bank account

5. Favourable tax treatment and hence are often attractive vis-à-vis short-term and ultra-short term debt funds

What works against arbitrage funds?

(Image source: freepik.com)

Higher churning may lead to higher expense ratios: When there are ample arbitrage opportunities and markets are trending upwards, arbitrage funds tend to churn their portfolios frequently and under such circumstances, the expense ratios of arbitrage fund may shoot up.

[Read: How SEBI’s Diktat On ‘Expense Ratio’ Will Benefit Investors]

Short-term returns may not be attractive: If you have a time horizon of less than one year, short-term debt funds may still be better options for you. Return potential of arbitrage funds is highly subjective to the market conditions.

The verdict:

An arbitrage fund carries low risk and the returns you can expect could be in the range of 6%-7% p.a. – depending on the market conditions and fund manager’s ability to reap rewards from arbitrage opportunities. Importantly, there are hardly any outliers, which means, the performance of all arbitrage funds, irrespective of who’s managing them, is more or less the same.

To park money for the short-term (upto 2 years), you may consider an arbitrage fund.  It makes sense particularly if you are in the 20% or 30% tax bracket. 

Alternatively, you may consider short-term debt funds for an investment horizon of upto 2 years. But if you have an investment horizon of less than 1 year, low duration and money market funds would be the preferred choice.

And if you have an extremely short-term time horizon (of less than 6 months), you would benefit from investing in liquid funds and ultra-short duration funds. Remember that investing in debt funds is not risk-free. 

[Read: 5 Facets To Look Into While Investing In Debt Mutual Funds]

In the current scenario where interest rates are trending up owing to inflationary pressures, shorter maturity papers look attractive, and fund houses, too, are aligning their portfolios accordingly.

However, make sure you have a clear objective in mind, know your financial goals, risk profile and the time horizon before goals befall before you invest your hard-earned money. Accordingly, you need to invest based on your personalised asset allocation. 

Prudent investing and financial discipline are vital ingredients for long-term financial well-being.

[Read: The 9 Thumb Rules To Achieving the Epitome of Financial Wellbeing] 

Editor’s note:

Do you know unusual and lesser-known funds are capable of generating big gains for you, the investor?

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Recognize hidden gems before the crowd discovers them.

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Happy Investing!

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