Arbitrage funds have been grabbing much attention from investors. And as much as you are tempted to invest, it is important to understand what an arbitrage fund is and how it really works. In this video, we tell you all about Arbitrage Funds.

Topics Covered
00:00 Introduction
00:50 WHAT ARE ARBITRAGE FUNDS?
02:32 HOW DOES AN ARBITRAGE FUND WORK?
06:52 OPPORTUNE TIME TO BUY ARBITRAGE FUNDS
09:26 PERFORMANCE OF ARBITRAGE FUNDS
11:39 ETMONEY OPINION


👉 WHAT ARE ARBITRAGE FUNDS?
The word “arbitrage” refers to the practice of buying something in one place and selling it somewhere else where the price is higher. In doing so, the person conducting the arbitrage aims to make a profit from this transaction, and more importantly, he does so without changing any part of the item itself which can be a stock, currency, commodity, or any other tradeable item. So while the essence of the fund is equity by composition, the arbitrage fund has a hybrid fund feel to it and perhaps that’s why the SEBI classifies them under hybrid rather than equity


👉 HOW DOES AN ARBITRAGE FUND WORK?
Three things characterize an arbitrage fund
- There is a simultaneous buy and sell transaction
- It is the same security that is being transacted
- The activity in question is happening in two different markets

Waiting for the F&O expiry is not the only strategy that the arbitrage desk employs. In some cases, fund managers unwind their spot and future positions even before the expiry if an opportunity presents itself for generating higher returns. Likewise on the date of expiry, if the price differential for the subsequent month maturity still exists in that case too, many fund managers look to roll over the futures position to capture the delta that’s 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

Exchange arbitrage - occurs when the price of a particular security is different across two stock exchanges.
Index arbitrage - looks to exploit the difference in the index value and the individual prices of its constituent stocks.


👉 OPPORTUNE TIME TO BUY ARBITRAGE FUNDS
Arbitrage funds are perhaps the only category of mutual funds where volatility works to the investor’s advantage

To get a better hang of this, we compared the movements of the NIFTY 50 Arbitrage Index with the India VIX index. We found, generally and as expected the higher the VIX the better has been the performance of arbitrage funds.

So what happens when there is high volatility in the stock markets?
The price difference between a security’s spot and futures which is also called the spread it tends to rise which is consequently exploited by the arbitrage seeker. Go for arbitrage funds when the spreads are wide enough


PERFORMANCE OF ARBITRAGE FUNDS
Like most mutual funds, the returns from arbitrage funds are not 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 8 to 9%. But when the spreads narrow, the returns from these funds go down to a 4 to 5% range

So if you are someone who believes in averages the assumption of a good return for arbitrage funds based on historical data is about 6% plus/minus 50 basis points

Now, arbitrage funds are often compared to short-duration debt funds like a liquid fund or an ultra short term fund, and even a money market fund. The comparison isn’t fair as liquid funds have a lower standard deviation which means they are less volatile than arbitrage funds. And secondly, it’s important to consider taxes when comparing liquid and arbitrage funds.

👉 ETMONEY OPINION
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 very short term

- 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 kind of arbitrage play

But there are some points in time that are ripe for arbitrage opportunities that do work to an investor’s advantage. Plus if we add the fact that there is a taxation benefit arbitrage funds do come across as a good option for cautious investors who want to park their surplus money when there is a persistent fluctuation in the market

#ETMONEY #Arbitragefunds #MutualFunds

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