What is Arbitrage Fund & How Does it Work?

An investor’s risk appetite plays a vital role in his/her financial planning. Understanding one’s risk tolerance is essential because this way, you have a clear idea about which investment avenues you may consider for diversifying your investment portfolio. When you diversify your mutual fund portfolio, you also balance risk as it is almost impossible for all the sectors / asset classes to face a downfall at once. If you wish to have a well-diversified portfolio, it is better that you have a mix match of various financial tools.Arbitrage fund

If you are an investor who doesn’t want to take high risks but wish to invest in a moderately risky financial vehicle, you may consider investing in arbitrage funds. These mutual funds that try to take advantage of market vagaries by buying and selling securities in an opportunistic and calculative manner. If you wish to find more about what are mutual funds and arbitrage funds, read further.

What are mutual funds?

Regulator of the securities market in India, Securities and Exchange Board of India or SEBI defines a mutual fund as, “Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.

Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time.

To simplify, a mutual fund is a professionally managed investment fund which seeks to achieve capital gains for investors sharing a common objective. AMCs collect money from investors sharing a mutual investment objective and invest this pool of funds in various market securities like equity, debt, treasury bills, government securities, etc. across the Indian economy. Depending on the performance of these securities in the market, the value of a mutual fund may increase / decrease.

Investors receive mutual fund units in accordance with the money invested and depending on the existing NAV or net asset value of the fund.

What is an arbitrage fund?

An arbitrage fund is an open ended equity fund which is expected to follow an arbitrage strategy where of the total assets, a minimum of 65 percent investment must be made in equity and equity related instruments. This is a one of its kind mutual fund that seeks to leverage from the changing price of cash and derivative segments of equity markets to generate gains. These gains are solely dependent on the performance of the assets in the market. Arbitrage funds are categorized as hybrid mutual funds as they invest portions of their portfolio in both debt and equity related instruments.

These funds are often considered by investors who wish to take a moderate risk, in order to make the most out of volatile market conditions.

How does an arbitrage fund work?

Arbitrage funds mostly function in two markets – (equity) cash and derivatives (futures). The futures market, unlike the equity market, take into account a future hypothetical/anticipated price for the valuation of the stocks. The current/existing price of security is termed as the spot price. The futures trading date predetermined in the futures contract is specified as the maturity date.

Let’s take an example to understand better how arbitrage funds work:

If an arbitrage fund purchased 2000 shares from company A at the price of Rs. 10 per share in January and sold these for Rs. 20 at the end of May as per futures contract, there are two considerations:

Situation 1 – 

The stock price at the maturity date: Rs. 30

Profit/Loss of the spot transaction in the cash market: (30-10) x 2000 = Rs. 40,000

Profit/Loss of futures transaction in futures market: (20-30) x 2000 = Rs. – 20, 2000

Overall profit made by the arbitrage fund: 40000 – 20000 = Rs. 20,000

Situation 2 –

The stock price at maturity date: Rs. 15

Profit/Loss of the spot transaction in the cash market: (15-20) x 2000 = Rs. – 10,000

Profit/Loss of the spot transaction in the futures market: (30-15) x 2000 = Rs. 30,000

Overall profit made by the arbitrage fund: 30000 – 10000 = Rs. 20,000

Although in the above example, the arbitrage fund manages to make profits irrespective of the market vagaries, this may not be true in real life, and the fund may even suffer losses.

However, there bear in mind that there is no assurance or guarantee that the objective of the arbitrage fund will be achieved. Since this fund does not assure or guarantee any returns, it is advisable that you take the advice of a professional consultant before investing.