Arbitrage funds : All that you need to know about this investment fund
Tony is a clever shopkeeper. He sells milk and bread early in the morning and paan and cigarette late at night. He has made the front portion of his home a convenience store, and the back his small kitchen garden.
During monsoon, you will find umbrellas for sale, and in the winter, warm socks on display.
If my wife visits his store, she will end up buying things that were never in her shopping list.
Tony is not alone. There are many like him in the financial market as well – pulling out something fancy just to grab your attention. And right now the fanciest one is the Arbitrage Fund from mutual fund houses. So, what is an Arbitrage Fund? Why is there a renewed interest in them right now? Let us learn.
The word arbitrage means simultaneous buying and selling of an asset in different markets to benefit from the price difference. We know that stocks are traded in the Bombay Stock Exchange (BSE) and at the National Stock Exchange (NSE) for cash.
There is another market where stocks are traded for a future cost. And that market is called the Derivatives Market. Let us assume that a stock is being traded at the BSE for Rs. 100 and in the Derivative Market, it is being traded at Rs. 102.
In that case, an Arbitrage Fund will buy the same number of that particular stock at the BSE and sell the equal number of that particular stock at the Derivative Market to benefit from the price difference.
Normally the price difference is triggered by any news related to that particular stock or its quarterly or annual results. There can also be any external news affecting the price difference.
For example, any news of instability in the Middle East will trigger a price difference in energy companies. Please note that these price differences don’t last long and so also the opportunities. Arbitrage Funds by nature perform best in a volatile market. A huge surge or drop in the market is the opportunity it waits for. Although it trades in equity, it is not exposed to the risk of the equity. This is because it tries to benefit from the price difference without investing in equity. And because of this risk-free investment, Arbitrage Funds are normally compared with liquid funds for performance comparison. Because it is perceived as a safe investment alternative, it has seen a huge surge of investments in recent months. As of August 31, more than 68,000 crores have been parked in Arbitrage Funds. Another attraction of Arbitrage Funds is that, because they trade more than 65 per cent of their assets in equity, they are considered an equity fund for taxation part. Because of this nature they score high as post-tax return, especially for individuals who are in the 20 or 30 per cent tax brackets. But, be aware that Arbitrage Funds are not for wealth creation and only meant for short-term parking of your investments.
And since there is a surge of investments in Arbitrage Funds, in the future, fund managers will have a tough time finding arbitrage opportunity and thus affecting the returns.