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If you invest in mutual funds, you know it comes with inherent risks and complexities. For investors seeking to navigate the market while mitigating certain risks, arbitrage funds can offer an attractive option. This guide delves into the world of arbitrage funds in India, providing a comprehensive overview of their functioning, benefits, and limitations, empowering you to make informed investment decisions.

What is arbitrage?

The foundation of arbitrage funds lies in the concept of arbitrage. This involves exploiting price inefficiencies between two or more markets for the same asset. In the context of arbitrage funds, the price discrepancy often occurs between the cash market and the futures market for stocks.

  • Cash Market: This refers to the traditional stock exchange where shares are bought and sold for immediate delivery.
  • Futures Market: This is a derivative market where contracts are traded for the future purchase or sale of an asset at a predetermined price on a specific date.

How do arbitrage funds work?

Arbitrage funds aim to capitalise on these price discrepancies by employing the following strategies:

  • Buying the undervalued asset: The fund manager identifies stocks trading at a lower price in the cash market compared to their corresponding futures contracts.
  • Selling the overvalued asset: The fund manager simultaneously sells the futures contract of the same stock, locking in the higher price.
  • Pocketing the difference: When the futures contract expires, the fund manager delivers the previously purchased stock, profiting from the price difference between the two markets.

Benefits of arbitrage funds

  • Low Risk: Compared to other equity funds, arbitrage funds are generally considered low-risk investments. This is because they exploit price inefficiencies, not relying solely on market movements for returns.
  • Stable Returns: While not guaranteed, arbitrage funds typically offer consistent and predictable returns, making them suitable for investors seeking stable income generation.
  • Tax Efficiency: Short-term capital gains from arbitrage funds held for less than 12 months are taxed at a concessional rate of 15% plus applicable surcharge and cess, compared to the regular tax rate for equity funds. Additionally, long-term capital gains exceeding ₹1 lakh are taxed at 10%, offering tax benefits to long-term investors.
  • Portfolio Diversification: Including arbitrage funds in your portfolio can diversify your holdings and potentially mitigate overall portfolio risk.

Limitations of arbitrage funds

  • Limited Returns: While offering stable returns, arbitrage funds generally provide lower returns compared to actively managed equity funds that invest directly in stocks.
  • Market Dependence: Although less susceptible to market fluctuations, arbitrage funds are not entirely immune to market conditions. Significant market disruptions can impact the potential for exploiting price inefficiencies.
  • Expense Ratio: Compared to index funds, arbitrage funds typically have higher expense ratios due to the active management involved in identifying and capitalising on price discrepancies.

Who should invest in arbitrage funds?

Arbitrage funds can be a suitable investment option for:

  • Risk-averse investors: Individuals seeking to minimise investment risks and prioritise stable returns.
  • Income-seeking investors: Investors seeking regular and predictable income generation from their portfolio.
  • Investors looking to diversify: Individuals seeking to diversify their portfolio by including low-risk assets alongside other equity or debt instruments.

Investing in arbitrage funds

Before you invest in arbitrage funds, it's crucial to:

  • Understand your risk tolerance: Assess your comfort level with potential market fluctuations and choose funds aligned with your risk profile.
  • Compare different funds: Research and compare various arbitrage funds offered by different fund houses, considering their expense ratios, track record, and investment strategies.
  • Seek professional advice: Consult a qualified financial advisor to understand if arbitrage funds align with your overall investment goals and financial plan.

Conclusion

Arbitrage funds offer a unique opportunity to benefit from market inefficiencies while mitigating certain risks compared to other mutual fund investments. However, understanding their limitations and aligning them with your investment goals and risk tolerance is crucial before incorporating them into your portfolio. By conducting thorough research and seeking professional guidance, you can make informed investment decisions and leverage the potential of arbitrage funds within your broader financial strategy.

Disclaimer: This blog is for informational purposes only and should not be considered financial advice. Please consult with a qualified financial advisor before making any investment decisions.

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