What are arbitrage funds: All you need to know before investing?

Arbitrage funds use a system-driven approach with algorithms to swiftly identify and execute arbitrage opportunities, ensuring efficiency and eliminating the need for manual intervention

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Arbitrage funds have emerged as an attractive investment option in India, particularly for those seeking lower risk and consistent returns amid market volatility. 

These mutual funds capitalise on price discrepancies between the cash and derivatives markets, allowing investors to lock in profits with minimal exposure to risk. 

Arbitrage funds use a hedged strategy, buying securities in the cash market and simultaneously selling them for future settlement.

 

This approach minimises risk, with returns derived from price differences rather than market direction. Typically, 65-85 per cent of the portfolio is invested in largecap stocks with arbitrage possibility, while 15-35 per cent is allocated to corresponding futures contracts. A portion is also held in cash or cash equivalents to ensure liquidity.

 

A standout feature of arbitrage funds is their system-driven approach, where algorithms automatically identify and execute arbitrage opportunities, ensuring swift action and eliminating manual intervention.

 

“I think arbitrage funds’ biggest advantages are their stability and tax efficiency. They deliver debt-like returns with equity taxation, making them ideal for short-term investments or emergency funds,” said Trivesh, chief operating officer (COO) Tradejini (online stock trading platform for equities, commodities, derivatives & currencies).

  How are arbitrage mutual funds taxed? 

 

The returns from arbitrage funds are taxed as equity funds, making them more tax-efficient compared to other fixed-income products.

 

Experts suggest some risks associated with arbitrage funds 

Arbitrage funds thrive on market volatility. When markets are flat, arbitrage opportunities diminish, potentially leading to below-average returns. This dependency on market movements can make performance unpredictable during stable periods.

 

As hybrid funds, arbitrage funds allocate a small portion of their portfolio to debt instruments. These are usually invested in short-term, low-risk securities like term deposits. While this minimises interest rate and credit risks, they are not entirely eliminated.

 

While arbitrage funds carry less risk, their returns are generally lower than pure equity funds, especially during bullish market phases. This makes them less appealing to investors seeking higher growth.

 

Who should invest in arbitrage funds? 

Arbitrage funds could be suitable for:

 

Conservative investors seeking better post-tax returns than traditional fixed-income options

 

Investors in higher tax brackets looking for tax-efficient returns

 

Those with a short-to-medium term investment horizon (6-24 months).

 

Investors looking to diversify their debt portfolio