Although Arbitrage Funds have been in the market for more than a decade, investor participation is still very low. This is primarily because of lack of information and inability to comprehend the potential returns of arbitrage funds. But before we tell you the benefits of investing in arbitrage funds, let us understand what they are and how they work.
What are Arbitrage Funds?
Arbitrage Funds are a type of equity scheme that takes advantage of and profits from the price difference of a stock in different markets, most common being the price difference in the spot and futures market. One can view it as a low-risk investment option as they do not work on the predictions of market trend but simply book profits on the spread in the spot and future prices of a stock. Let us look at a simple example to understand what is spread and how do these funds take advantage of this spread.
How does an Arbitrage Fund work?
Suppose shares of a company A are trading at Rs 100 on the stock exchange (spot market) today and at the same time stock is trading in the futures market for Rs 101, for delivery after one month. This is where the arbitrage opportunity exists, due to the difference in the price of the stock in the spot and futures market. So as an investor you can buy shares at Rs 100 and sell them in the futures market for Rs 101 and book a profit of Re.1, without worrying about the actual price of the stock. As an investor all you did was simultaneously buy and sell the same security in different markets and book profit.
Arbitrage Funds: Terms to Know
Cost of carry: It refers to the difference between the cost of a share at the time of purchase and the returns generated on it over time. Simply put,
Cost of carry = Futures price – Spot price
Alternatively, it is the cost incurred from the date purchasing a share until the time of its maturity.
Example: spot price of scrip A is Rs 2,000 and current interest rate is 8%. So, the cost of carry for a 1-month period will be:
2000* 0.08 * (30/365) = 13.2
For an arbitrage fund to perform well, the cost of carry has to be in the positive (i.e., future prices should be more than spot prices).
Volatility: It refers to the change in a share’s size. A higher volatility means that the share price can change drastically (increase or decrease) over a small time frame. Conversely, lower volatility means that share price remains fairly stable, with minor fluctuation, over a time period. As a result, for arbitrage funds to perform well, the market has to be volatile (or bullish).
Depth of market: It refers to the ability of a company’s shares to handle large trading of units without a significant impact on its price. Market depth indicates the liquidity of that security. A liquid stock that has large number of buyers and sellers will not show striking price movement whereas in the case of a less liquid stock, high trading would result in significant price fluctuation.
Top 4 benefits of arbitrage funds
The four most important benefits of arbitrage funds are as follows:
- Minimal risk in volatile markets
Many people find it difficult to stay invested in equity schemes due to high volatility. But as the volatility in the market increases so does the opportunity for arbitrage, making them a very good investment option in volatile markets. And as the profits are pre determined, arbitrage funds have minimal risks. In fact, these funds are one of the few low-risk investment instruments perform well in volatile markets.
So if you are wary of investing in equities in volatile markets and want to invest in schemes which carry minimal risk then you can invest in this type of equity scheme without being worried about the market volatility.
- Benefit of equity taxation
Another reason why arbitrage funds have an ace up in their sleeves is when we look at these funds from taxation purpose. These funds offer capital preservation and carry minimal risk, which is normally a characteristic of debt funds but being an equity scheme, they enjoy the taxation benefit of equity funds and profits arising from these schemes are exempt from tax if held for more than one year. Prior to the budget announcement in 2014, an investor would have earned similar returns in debt funds and arbitrage funds and so could invest in either of them, but with the new taxation policy, arbitrage funds definitely have an edge over debt funds which suffer from the disadvantage of long term capital gain tax of 20% with indexation and minimum 3 years of holding period. Post tax returns are the biggest advantage of arbitrage funds.
So if you have surplus cash and want to get the benefit of taxation on your investments you can look at these funds.
- Expected return
Since the profit in these funds is pre determined and ability to earn profits is on the availability of price difference of securities in different market, realistic post tax returns from these funds range from 6% to 7%.
- Short duration of investment
Arbitrage funds are essentially a proxy to liquid funds. To be able to capitalize on the benefits of these funds, you would have to stay invested for one full expiry cycle. So, if you are more keen on making short-term investments, arbitrage funds should be one of your instruments.