Arbitrage mutual fund- An option for smooth sail in market volatility
Last Updated : July 7, 2016, 11:55 a.m.
Arbitrage funds, a type of mutual fund, which maximizes the arbitrage opportunities between spot (cash) and derivatives (Futures & Options) markets. Arbitrage is a mean to earn risk-free profits by taking advantage of inefficiencies in the market.
Operational Methodology
Let us understand the operation of arbitrage funds with the help of an example. Let say the share price of a company in the spot market is Rs 500 today and the price of its June futures contract is 550. If you purchase 200 shares of the company in the cash market and sell 200 futures, you will then collect a gross profit of Rs 10,000 today. Upon the expiry of June futures contract, the futures and spot price will converge. Now comes the role of expiry price. If the expiry price is Rs 580. You will make a profit of Rs 80 per share on the shares that you purchased or get the delivery in cash market. While, you will have to bear a loss of Rs 30 per share in your futures. The net profit, before deducting other expenses, will be Rs 50 per share or Rs 10,000 on 200 shares. But, what will be the outcome if the price of the share falls to Rs 480 on expiry date? You will have to deal with a loss of Rs 20 per share you purchased or took delivery. But will make a profit of Rs 70 per share on futures. So, you can arbitrage to compensate for the loss in one security with the gain made in another.
Advantages
- With minimal risk, you can earn good returns in the short-term by investing in arbitrage funds.
- Arbitrage funds can offer returns same or more than the low-risk liquid funds, a type of mutual fund that invests mainly in money market instruments such as treasury bills, certificate of deposits, fixed deposits, commercial papers, etc.
- Being an equity oriented fund, arbitrage fund remains tax free on long-term capital gain. Long-term means holding the instrument for 12-36 months and above. While, the long-term capital gain on liquid funds gets taxed at 30%. Short-term capital gain on arbitrage funds and liquid funds attracts tax rate of 15% and as per the individual tax slab, respectively. Say If your slab turns out to be 30%, then you will be paying more tax on the redemption of liquid funds compared to arbitrage funds. Short-term applies to the period of holding the instruments for less than a year.
- Dividend income from arbitrage funds are tax-free.
- Arbitrage fund returns are higher in volatile market conditions.
- Arbitrage funds tend to perform well in bear markets as the expectancy of volatility is huge there.
Things to keep in mind
- You must take into consideration the transaction costs such as brokerage, service tax and Securities Transaction Tax (STT), etc.
- You will be told by the broker to make a margin for your futures contract. You must consider the opportunity cost of maintaining that margin.
- Be aware of short-term volatility.
- You must do an arbitrage trade when there exists a large difference between spot and futures market to cover all the costs. Another arbitrage opportunity arises when there is a difference in the price of a share listed in Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).
| Top-Performing Schemes | Riskometer | NAV | 1-Year Return | 2-Year Return | 3-Year Return | AUM | Asset Allocation |
|---|---|---|---|---|---|---|---|
| HDFC Arbitrage Fund | Moderately Low Risk | Rs. 18.82 | 7.10% | 7.70% | 8% | Rs. 3.67 Cr | Equity-67.45% Mutual Funds-29.23% Others-3.32% |
| L&T Arbitrage Opportunities Fund | Moderately Low Risk | Rs. 11.74 | 6.30% | 7.2 0% | N.A. | Rs. 136 Cr | Equity-70.81% Debt-15.17% Cash/Call-13.73% Others-0.29% |
| Kotak Equity Arbitrage Fund | Moderate | Rs. 22.80 | 6.55% | 7.20% | 8% | Rs. 914 Cr | Equity-71.30% Debt-21.49% Others-7.21% |
| ICICI Prudential Equity Arbitrage Fund | Moderate | Rs. 21.16 | 6.70% | 7.20% | 7.90% | Rs. 1,028 Cr | Equity-58.03% Debt-20.48% Cash/Call-13.23% Money Market-5.82% Others-2.40% |
| IDFC Arbitrage Fund | Moderately Low Risk | Rs. 20.17 | 6.30% | 7% | 7.70% | Rs. 1,313 Cr | Equity-69.49% Debt-16.76% Others-13.75% |
| Reliance Arbitrage Advantage Fund | Moderately Low Risk | Rs. 16.32 | 6.40% | 7.50% | 7.50% | Rs. 1,401 Cr | Equity-72.45% Debt-22.57% Others-4.98% |
Note-Sourced as on Oct 15, 2016
These arbitrage funds have offered a return of 6%-9% in a period of 1-3 years with expense ratio well below 1%.
As you have got the necessary information pertaining to arbitrage mutual fund, you stand in a better position to take a call on the same. Do assess your risk profile and investment horizon before choosing the option of arbitrage fund. Enjoy a good run with arbitrage funds and immune your investment from market risk to a larger extent.