What Are Arbitrage Funds? Meaning, Features & More

Arbitrage refers to a market activity in which a security, commodity, currency or other tradable item is bought in one market and sold simultaneously in another, to profit from price differences between the markets.

Many investment experts believe this practice is good for generating profits. Investors who don’t have the knowledge to leverage arbitrage opportunities may opt for arbitrage funds.

Arbitrage Funds: Meaning & Definition

Arbitrage funds are mutual funds that leverage the price differentials of securities across different markets. They buy and sell these securities simultaneously to generate profits.

In short, these funds aim to generate returns by simultaneously buying and selling securities in cash and derivatives markets to exploit the price differentials.

Related: Equity Funds | Debt Funds | Hybrid Funds

Features Of Arbitrage Funds

Here are the main features of arbitrage funds that can help you understand these funds better.

A. Equity-oriented Funds: Arbitrage funds are equity-oriented hybrid funds as they invest at least 65% in equities and equity-related instruments.

B. Unique Approach to Capitalizing on Market Opportunities: Unlike other mutual funds, these funds do not invest and wait for long-term growth. Instead, they exploit price discrepancies between specific markets, like the cash and futures markets, to generate short-term profits.

C. Relatively Low Risk: Compared to pure equity funds, arbitrage funds generally exhibit lower risk. While they invest primarily in equities, they strategically utilize debt instruments to facilitate their arbitrage strategies.

D. Active Management: Successful arbitrage strategies require active management by skilled fund managers who monitor market conditions and execute trades to exploit arbitrage opportunities effectively.

Advantages

Let’s look at the advantages an investor gets when he/she invests in arbitrage funds.

1. Not all investors possess the expertise to leverage arbitrage opportunities. Arbitrage funds give them the potential to generate returns through this strategy.
2. If you are a risk-averse investor, arbitrage mutual funds can be a good investment option for you due to their low-risk profile.
3. Arbitrage funds generally offer high liquidity. It means investors can buy and sell the units of the fund easily. This is good for investors who may need to access their money quickly.
4. Arbitrage funds are less impacted during a volatile market compared to other low-risk investments.

Disadvantages

These funds also carry some limitations. Let’s discuss about them.

1. Investors are completely dependent on the expertise of fund managers. Hence, they have no control over decisions made to leverage arbitrage.
2. Arbitrage opportunities are often small making the potential for high returns limited.
3. These funds may have higher expense ratios due to the active management involved in identifying and capitalizing on arbitrage opportunities.
4. The success of arbitrage funds relies on the existence of market inefficiencies, which can be scarce, especially in efficient markets.

Taxation

Due to their equity nature, arbitrage funds are taxed similarly to equity funds. Here are the taxation rules:

1. Short-Term Capital Gains (STCGs): If you sell your investments before the holding period of one year, a tax of 15% will be deducted on gains on investments.

2. Long-Term Capital Gains (LTCGs): If you sell your investments after the holding period of one year, an LTCG of up to 1 lakh is tax-free. Over this amount, a tax of 10% will be deducted from gains on investments.

FAQs

Note– This guide is for educational purposes and should not be considered investment advice. Investors should conduct their research before investing in any fund.