As the popularity of mutual-funds increases, fund houses continue to offer innovative products for varied investment objectives. Traditionally, you can choose between debt- or equity-oriented funds. Innovative investors prefer a more hybrid approach when it comes to wealth-creation.
Arbitrage Funds are hybrid (largely equity-oriented) funds, which allow you to get an edge in returns through the price difference of a stock. Is this possible? Yes, unlike traditional equity funds, where you buy a stock portfolio and hold on to it till you make profits; these funds allow for simultaneous purchase and sale of underlying equity-based securities on different exchanges.
How it works is, these funds buy stocks at their current price (available on stock exchanges) and sell on future prices or contracts (futures exchanges). What you need to note here, the difference between current and future stock prices may be minimal, which is why the funds will need to keep trading an entire day to earn profits. The two primary markets in which these funds trade are, cash and futures markets.
The cash market is also called the stock market, which means the current stock price, is the ‘spot’ price. The futures market reflects a ‘future’ or ‘anticipated’ price of a stock, the future date is called the maturity date.
Let’s see how these funds work with an example: The stock of ABC Ltd. trades in the cash market at the price of ₹ 1200/- and at the price of ₹ 1225/- in the futures market. On the maturity date when the prices coincide, the fund will sell these stocks in the futures market and generate a risk-free profit of ₹25/- per stock.
Arbitrage Funds Recommended by Angel BEE
Buying at lower stock prices in the cash market and selling at higher (expected) prices in futures markets works great in positive or bullish market cycles. But what happens when markets are bearish and anticipated stock prices are low? If stock prices are expected to drop in the future, the arbitrage funds will price the futures contracts lower to buy at maturity date and sell the equivalent stocks at current, high, spot prices.
These funds leverage market inefficiencies to generate profits in the short- to medium-term. Moreover, the most recommended arbitrage funds will also have fixed-income generating securities like bonds or other debt components. Which means, when opportunities for arbitrage are close to impossible, the safer underlying securities will continue to generate returns.
Top Arbitrage Funds in India
Investors usually shy away from market volatility, but for arbitrage funds, market volatility are good news. The chances of returns are greater in turbulent markets. The top funds harness the price differential between cash and futures markets to get maximum profits for their investors.
Moreover, market experts say that, usually during the short-term, investors should see high returns in times of high volatility and low returns during low volatility cycles. This is because of the direct relationship between NAV of underlying equity-oriented securities and turbulent markets.
Everything You Need to Know About Arbitrage Funds
Hybrid Mutual-Funds: Arbitrage funds are a type of hybrid, equity-oriented funds. These funds trade underlying securities simultaneously on different exchanges. The most heavily traded markets are cash and futures markets.
Great Returns: The returns of these funds are based on price differences on cash and futures exchanges. The same proportion of stocks are bought and sold simultaneously. During bullish market cycles, the stocks are bought at low prices in cash markets and sold at high future prices. When future market prices are expected to be low (in bearish cycles), these funds sell stocks at higher current prices and buy at lower future prices. The current price of a stock is also called the ‘spot’ price.
Leverage Market Volatility: These funds make the most of market volatility to get the best returns. The NAV of underlying stocks fluctuates in proportion to changes in market cycles. Usually, when market volatility is low, these funds generate low returns, when market volatility is high, the returns are higher.
Diversification: Most of these funds comprise of equity- and debt-oriented securities. During market turbulence the fund leverages its equity-oriented, underlying securities to take advantage of varying market cycles for maximum profits. Likewise, when markets are stable, the debt-oriented securities continue to generate returns. The best funds comprise of quality securities for best returns.
Tax Treatment: These funds are treated the same as equity-funds for the calculation of short-term capital gains (STCG) and long-term capital gains (LTCG). Moreover, they are considered more tax-efficient than purely debt-based funds.
Why Arbitrage Funds?
Arbitrage funds are the best if you are a risk averse investor, who is hesitant about putting money in unpredictable markets. The transactions are considered low-risk buy & sell opportunities in cash and futures markets. They give you the best returns especially in intermediate investment horizons.
The rate of returns, historically, is believed to be between 7%-8%, according to market experts. However, there is no guarantee of consistently getting these numbers, because, market movements are not guaranteed.
If you’re looking at holding your investments for at least 6 months to 5 years, these funds are your best option. Moreover, if you have short- to medium-term financial goals, these funds are a good option.
Get Better Returns with Arbitrage Funds
Arbitrage funds are best for investors who have a low appetite for risk and, do not want to participate directly in the markets. Before you consider investing in these funds, you need to evaluate your knowledge and understanding of market cycles and, the subsequent repercussions on other related factors like prices of securities and NAV. You will also need to define (and in some cases re-align) your financial goals. The reason is, these funds are ideally suited for short- to medium-term financial goals between 6 months to 3 years (5 years only if the fund outperforms its benchmark).