Investors often seek low-risk investment options that offer stable returns without exposing their portfolios to excessive volatility. One such investment avenue is arbitrage funds, which leverage market inefficiencies to generate returns. These funds are particularly attractive for conservative investors who want equity exposure with minimal risk.
In this Guide On What Arbitrage Funds, we will explore arbitrage funds, their working mechanism, benefits, and why they are gaining popularity among investors.
Arbitrage Funds Meaning
To understand arbitrage funds better, let’s define arbitrage funds meaning first. Arbitrage funds are a type of mutual fund that capitalizes on price differences of securities between different markets. They primarily invest in the cash market and derivatives (futures) market, aiming to generate returns by exploiting temporary price discrepancies.
Since these funds profit from market inefficiencies rather than stock price movements, they are considered low-risk investment options. Their unique structure makes them an excellent choice for investors looking for stable yet tax-efficient returns.
How Do Arbitrage Funds Work?
1. Exploiting Price Differences
The fundamental principle behind arbitrage funds is buying low and selling high simultaneously in different markets. Here’s how it works:
The fund buys stock in the cash market.
At the same time, it sells a futures contract of the same stock in the derivatives market.
When the futures contract expires, both prices converge and the fund earns a risk-free profit from the price difference.
Since these funds rely on market inefficiencies, they are not directly affected by overall market trends. Whether the market is rising or falling, arbitrage funds continue to generate returns as long as price discrepancies exist.
2. Market Volatility Creates More Opportunities
One of the reasons why arbitrage funds perform well in volatile markets is that increased fluctuations create more price mismatches between cash and futures markets. The greater the difference, the higher the arbitrage profit.
This makes arbitrage funds a suitable option for investors who want a stable investment avenue even during uncertain market conditions.
3. Conversion at Expiry
When the futures contract reaches its expiry date, both cash and futures prices align. At this point:
- The fund squares off its position by selling the stock in the cash market and closing the futures position.
- The profit made from the difference in buying and selling prices is the return for investors.
- This cycle repeats continuously as new arbitrage opportunities arise, ensuring consistent returns with minimal risk exposure.
Why Should You Invest in Arbitrage Funds
1. Low-Risk Alternative to Equity Funds
Unlike traditional equity funds that fluctuate with stock market movements, arbitrage funds hedge their positions to minimize risk. Investors who prefer equity exposure but want lower volatility can benefit from these funds.
2. Tax Efficiency
One of the biggest advantages of arbitrage funds is their tax treatment. Since they are classified as equity-oriented mutual funds, they enjoy lower tax rates compared to debt funds.
Long-term capital gains (LTCG) tax is applicable if the investment is held for more than one year, which is lower than debt fund taxation.
This makes arbitrage funds an attractive option for tax-conscious investors looking for stable returns.
3. Suitable for Short-Term Investments
Investors looking for short-term parking of funds can consider arbitrage funds instead of traditional bank deposits or liquid funds. They provide better returns than fixed deposits while maintaining liquidity.
4. Ideal for Market Uncertainty
During periods of market volatility, traditional equity investments can be risky. However, since arbitrage funds profit from price discrepancies rather than stock appreciation, they offer a safe investment avenue during uncertain times.
5. Diversification in an Investment Portfolio
A well-diversified portfolio includes different asset classes like equity, debt, and alternative investments. Arbitrage funds act as a bridge between equity and debt, adding stability and consistency to an investor’s portfolio.
Conclusion
Arbitrage funds mean they are mutual funds that profit from price discrepancies in different markets. They work by simultaneously buying stocks in the cash market and selling them in the futures market. They are low-risk, tax-efficient, and ideal for short-term investments.
They offer a hedge against market volatility, making them a safe investment choice during uncertain times.
Investors looking for a safe yet rewarding investment should consider adding arbitrage funds to their portfolio. However, as with any financial decision, it’s essential to assess your financial goals and risk appetite before investing. By understanding arbitrage fund and how they function, investors can make informed decisions to enhance their financial stability and long-term wealth growth.
