Arbitrage Funds: Understanding the Basics and How to Pick the Best Ones for Your Portfolio?

Before understanding the fundamentals of arbitrage funds, let us understand its concept. With the festive season in full swing, you must have noticed price differentiation of different products online and offline. For instance, a mobile phone which may cost ₹10,000 offline is available for ₹9500 online. Suppose you buy this phone online at ₹9500 and sell it at ₹10,000, you bag a profit of ₹500. Arbitrage funds work in a similar manner. They cash in on the price differentiation in different markets to generate returns.

What are arbitrage funds?

Arbitrage involves buying and selling securities in two different markets to profit from price differentiation. Funds that deploy this principle are called arbitrage funds. The two different markets are the cash market and the future market.

The cash market is the one where one buys the stock at its current price, while the futures market is the one where one buys or sells the stock at a predefined price in the future. Let’s understand the workings of an arbitrage fund with an example.

Suppose a fund buys 5000 shares of a company at ₹500 per share in the cash market. It decides to sell them at ₹ 05 in the futures market. If all goes well, the fund manager locks in a profit of ₹ 25,000 (5000 X 5).

Arbitrage fund returns

Arbitrage funds have witnessed net inflows of over ₹1 lakh crore in the last one year . As per data, an average arbitrage fund has delivered 7.33% returns over the last 12 months . On digging a little deeper, it is revealed that 18 out of 25 arbitrage funds have delivered more than 8% returns .

Benefits of investing in arbitrage funds

Here are some potential benefits you get by investing in arbitrage funds:

• Helps make you the most of volatile markets

Markets are inherently volatile. However, it is this volatility that creates arbitrage opportunities. When markets go up and down regularly, arbitrage opportunities become more frequent. Arbitrage mutual funds can benefit from this volatility by taking advantage of short-term price fluctuations.

• Decent returns

Arbitrage fund returns have been decent. They are higher than traditional instruments like fixed deposits. Also, their taxation, like equity funds, makes them more tax-friendly compared to fixed deposits.

How to pick the best performing arbitrage funds?

To pick the best arbitrage funds, look out for these things:

• Fund’s long-term returns

Analyse the fund’s long-term returns and see the consistency in returns. You can find the data on news portals and other financial websites. While past returns are essential, note that they may not present the true picture of a fund’s future performance.

• Fund’s underlying securities

Check out the stocks of companies where the fund is investing its money and the industry where these companies operate. It shouldn’t be too concentrated.

• Fund manager’s track record

Evaluate the fund manager’s track record and performance, especially in handling arbitrage strategies. See how well he has navigated markets and driven the fund’s overall performance.

• Size of the fund

If a fund is too big, it may not be able to find enough arbitrage opportunities. This is because arbitrage opportunities are short-lived, and a big fund may find it challenging to effectively invest a large amount of money to benefit from them.

• Expense ratio

Check the fund’s expense ratio. A higher expense ratio may reduce your overall gains in the long run.

Wrapping it up

If you have an investment horizon of up to a year, you can invest in arbitrage funds. While they help you benefit from price differentiation, they are not entirely risk-free and, like mutual funds, are subject to market risks.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.