Table Of Contents
- HOW DOES AN ARBITRAGE FUND WORK?
- OPPORTUNE TIME TO BUY ARBITRAGE FUNDS
- PERFORMANCE OF ARBITRAGE FUNDS
Arbitrage is the practice of taking advantage of price differentiation in two different trading positions. For eg. Buying a stock in cash market & selling the same stock in futures market to take benefit of the price difference. Or purchasing something in one location and then selling it at a greater price in another location. These opportunities of differences in the prices are available for short term and gets corrected quickly. Hence, an arbitrage trader does not leave its position open. Therefore, it is less risky to any other investment strategy. In terms of returns, it delivers better than FD interest and less than debt or equity.
One can take advantage of arbitrage investment strategy through the Mutual Funds scheme that is being managed by professional investment managers. It also provides long term capital gain benefit if one holds it for more than a year, as per SEBI’s regulations.
Three things characterize an arbitrage fund:
– There is a simultaneous buy and sell transaction
– It is the same security being transacted
-The activity in question is happening in two different markets.
Waiting for the F&O expiry is one of the many strategies the arbitrage desk employs. Fund managers unwind their spot and future positions even before the expiry if an opportunity presents itself to generate higher returns. Likewise, on the expiry date, if the price differential for the subsequent month’s maturity still exists, many fund managers look to roll over the futures position to capture the delta available on the table.
Now while the cash-and-carry approach is the more commonly used arbitrage technique, there are a few more strategies that fund houses are known to apply in different capacities.
Among others, below are the two strategies followed by the professional arbitragers:
a) Exchange Arbitrage – occurs when the price of a particular security is different across two stock exchanges.
b) Index Arbitrage – looks to exploit the difference in the index value and the individual prices of its constituent stocks.
Arbitrage funds is the only category of mutual funds where volatility works to the investor’s advantage.
For better understanding, we compared the movements of the NIFTY 50 Index with the India VIX.
Generally higher the VIX, better the performance of arbitrage funds. What happens when there is high volatility in the stock markets? The price difference, also called the spread, between stocks spot & futures, tends to rise and is consequently exploited by the arbitrage seeker. Go for arbitrage funds when the spreads are wide enough.
Like most mutual funds, the returns from arbitrage funds could be more stable and depend on how much of a spread is available. When volatility and, therefore, the spreads are high, arbitrage funds have historically offered as high as 9%. But when the spreads narrow, the returns from these funds go down to a 4 to 5% range.
If you believe in averages, the assumption of a good return for arbitrage funds based on historical data is around 6%.
Arbitrage funds are often compared to short-duration debt funds like liquid funds, ultra-short-term funds, and even money market funds. The comparison isn’t fair as liquid funds have a lower standard deviation, meaning they are less volatile than arbitrage funds. And secondly, it’s important to consider taxes when comparing liquid and arbitrage funds where the latter has lower long term capital gain tax.
Arbitrage funds aren’t riskless. There are a few risks involved, such as
- Performance risk – the spot and futures position is marked-to-market daily. You can have negative returns from an arbitrage fund in the concise term.
- Lack of Opportunities– The lack of arbitrage opportunities is another risk that these funds face, and it doesn’t help that there are only about 140 stocks that are qualified for any arbitrage play.
However, some points in time are ripe for arbitrage opportunities that work to an investor’s advantage. Adding the taxation benefit, arbitrage funds are a good option for cautious investors who want to park their surplus money for short term when there is a persistent fluctuation in the market.