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A Guide On Arbitrage Funds | Company Vakil

What and How Arbitrage Funds function:

Arbitrage Funds function based on the mis-pricing of the equity shares in the place and the future market. The fund manager concurrently buys the shares within the cash market and then sells them in the futures or the derivatives market. The differences found in the cost price and the selling price becomes the return one earns. The following example may help to understand this concept better.

Illustration:

Let us suppose that the equity share of the company XYZ does trade in the cash market starting at Rs. 1220 and in the future market starting at Rs.1235. The fund manager, then, buys XYZ share from the cash market with Rs 1220 and the shorts of a futures contract in order to sell the shares with Rs 1235. Near the ending of the month, when the prices get coincided with each other, the fund manager will sell the shares in the futures market and obtain a profit free of any risk of Rs.15/- per share less than the transaction costs.

On the other hand, if the fund manager guesses that the price may fall in the future, he lessens the equity shares in the cash market and then he enters into a long term contract in the futures market. After that, he may short sell the shares in the cash market with Rs 1235. When reaching the expiry date, he then buys the shares in the futures market at Rs. 1220 in order to cover up his position and finally earns a profit of Rs 15.

Furthermore, in another scenario, the fund manager can buy an equity share for Rs. 100 from the National Stock Exchange, NSE in short and then sell the same amount at Rs 120 in the Bombay Stock Exchange, BSE in short, in order to make it all a return free of risk.

 Criteria of the Investors:

The money made by the Arbitrage funds are from the buy and sell opportunities of lower risks that that available in the future and the cash markets. On terms of the risk profiles, these funds are quite similar to the debt funds. In fact, many of the arbitrage funds actually use the “Crisil BSE 0.23% Liquid Fund Index” as their trade mark. The investors who are searching for an exposure into the equity markets can benefit from this fund because it is designed to help them with this. This program also helps them to be aware of the risks that associated with such equity markets. This is deemed to a lot safer option for the individuals who are averse to such risks and to help them store their extra money when there is consistent change in the market.

These types of fund help to leverage the inefficiencies of the market in order to generate required profits for the investors who invested in the middle grounds. Moreover, the fund managers also decided who gets the remaining assets, in addition to the claiming of positions within the equity market, in the instruments that generate a fixed income. When the fund manager is doing this, he makes sure that the investments he made are done so in the debt securities of high credit quality. This includes term deposits, debentures and zero coupon bonds. This method helps to keep the returns of the fund in line with the expectations at the time of scarce arbitrage chances.

As an Investor, the following things are to taken into consideration:

  • Risk

Since the businesses are moved forward on the terms of stock exchange, there has been no risk of counter party involved in those funds. Despite the fund manager is selling and buying the shares in the cash and the futures market, there has been no exposure about risks to the equities as in the case involving the other complex equity mutual funds. Even though the trip looks easy and smooth, it is suggested not to get too comfortable with these types of funds. Since more and more people start to trade into the arbitrage funds, there will be not many opportunities related to arbitrage available. The difference between the cash and the future market prices will go away, leaving very small amount for the arbitrage that is focused on the investors.

  • Return

Arbitrage Funds may become a good source of opportunity to make sensible returns for the investors who has the ability to understand it and then utilize all of it properly. The fund manager opts to generate the most amount using the price differentials in markets. From past records, it is observed that the arbitrage funds have been found to give returns in the range of 7% to 8% around a time period of 5 to 10 years. If someone is searching to earn medium returns through a portfolio that has been a perfect mixture of both the debt and the equity in an unstable market, these kinds of funds may be his thing. But one must keep in mind that there have been no guaranteed returns in this.

  • Cost

Cost is a very important factor especially when evaluating the arbitrage funds. These types of funds cost a yearly fee that is called the expense ratio. The expense ratio is used to express the percentage of the assets of the funds. It takes the fee of the fund manager and what the fund manager charges into consideration.  Because of frequent trading, these funds would incur huge costs regarding transactions. They also have a high turnover ratio. Furthermore, the fund may leverage the exit loads for a time frame of 30 to 60 days so that investors are discouraged from exiting early. All of these costs may lead to the increase in the ratio of expense for the fund. A high expense ratio asserts a downward pressure on the returns of the take-home nature.

  • Investment Horizon

The funds in discussion may be more suitable for the investors who own a short to medium term horizon of around 3 to 5 years. Since these funds charge the exit loads, one may take into consideration these only when he is ready to remain invested for a minimum period of at least 3 to 6 months. The investor also need to understand that the fund returns are majorly dependent on the existence of a very high level of volatility. Hence, choosing an investment of lump sum would make sense over the SIPs, short for “systematic investment plans”. In absence of such volatility, liquid funds will give far better returns than the normal arbitrage funds in the span of the same investment horizon. Therefore, the investor needs to keep the total market scenario in mind when he chooses the required type of funding.

  • Financial Goals

If the financial goals of the investor is of the short to medium type of range, then arbitrage funds are where he should invest in. Instead of having a regular savings bank account, he may use these funds to store the excess funds so that he can create an emergency fund and at the same time, he can earn higher returns on them. In case he has already invested in far riskier stores of equity funds, then he may begin an STP, short for Systematic Transfer Plan from the equity funds to a less risky store like arbitrage funds as he approaches the ending of the financial goal. This would diminish the overall risk of the investor’s portfolio. But it will reduce the returns as well. He cannot expect to earn returns in double digits within this type of funding.

  • Tax on Gains

These funds are seen as equity funds with the purpose of taxation. If the investor remains invested in them for a time frame of up to a year, then he can expect to make short-term capital gains (also known as STCG) which are taxable. The rate of tax for the STCG is 15%. If the investor remains invested in them for a time frame of more than a year, then the profit will be valued as a long-term capital gains (also known as LTCG). LTCG with the excess of Rs 1 lakh has been taxed at the rate of 10% excluding the benefit of the indexation. Instead of being attached to the pure debt funds, these are the funds which are suitable for the conservative type of investors who are in the higher tax margins in order to earn sufficient tax-efficient returns.

 Top 5 Indian Arbitrage Funds

In order to properly select a fund, one must fully calculate the fund market from various angles. There are several qualitative and quantitative parameters that are to be taken into consideration in order to decide which fund has to be selected to satisfy the requirements of the investor. In addition to that the investors has to keep his investment horizon, risk appetite and the financial goals in mind. The table given below depicts the top five type of arbitrage funds of India. The table is designed keeping in the previous records of return of the last year. The investors may choose any of the funds based on various types of investment horizon like the 5 or 10 years returns. The investors can add or subtract their criteria as they please.

 

Name of the Fund
“L&T Arbitrage Opportunities Fund Regular Growth”
“Reliance Arbitrage Fund – Growth”
“Kotak Equity Arbitrage Fund Growth”
“SBI Arbitrage Opportunities Fund Regular Growth”
“UTI Arbitrage Fund Regular Plan Growth”

Conclusion:

Arbitrage Funds, takes the advantage of the several types of price of securities in the cash form and the derivatives market in order to generate any return.Any of the arbitrage funds can be used by the investors to develop a better economic sense benefiting both himself and the overall economy.

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