An arbitrage mutual fund generates returns by encashing on the price variation in securities on different stock exchanges. The stocks in an arbitrage fund is not held for long. Arbitrage fund buys the stock in cash (spot) and simultaneously sells the same stock in the futures (derivatives) market. Difference between the spot price and future price is the return. Typically, an arbitrage fund will invest minimum 65% of the corpus in equity-related instruments. This makes arbitrage fund as an equity-oriented fund. Hence lower taxation as compared to debt funds.
BENEFITS OF ARBITRAGE FUNDS
- Arbitrage funds are low risk funds: One of the greatest benefits of these funds is that they are low-risk funds. There is virtually no risk involved in trading these funds in the longer-term since each security is purchased and sold simultaneously.
- Arbitrage funds flourish when the market is volatile: Another major benefit of arbitrage fund is that they are probably the only low-risk securities which actually flourish during highly volatile market conditions. Volatility provides the managers of arbitrage funds opportunities to buy and sell and encash on the price differential.
- Better post tax returns: Since Arbitrage funds are low risk, they are comparable to debt funds. However, they provide better post tax returns as compared to debt funds
DISADVANTAGES OF ARBITRAGE FUNDS
- They are not highly reliable: Returns are uncertain. Generally, actively managed equity funds outperform arbitrage funds in the long term.
- The expense ratio is high: the expense ratio of these funds is higher than index funds
- The payoff is unpredictable: Despite low-risk investments, returns are unpredictable and at times are 1-3% lower then debt funds.