What are Arbitrage Mutual Funds in India and how they work
Arbitrage mutual funds are low risk mutual fund schemes which aim to exploit the pricing mismatches in various segments of equity markets to generate risk free profits for investors. A common arbitrage opportunity arises from the pricing mismatch in cash and F&O (Future and Options) market.
For example - The share price of company ‘A’in cash market is Rs 100 and the futures price is Rs 110. On the expiry of the futures contract, the spot price (share price in cash market) and futures price will converge. If you buy 1000 shares of the company in the cash market and sell 1000 futures, you will lock in a gross profit of Rs 10,000 (Rs 10 x 100 shares) today itself irrespective of whether the share price rises or falls.
Suppose the share price of company ‘A’ on expiry is Rs 120 (spot and futures). In the cash market you will make a profit of Rs 20 per share (Rs 120 – 100) X 1,000 shares = Rs 20,000. At the same time, in the F&O market you will make a loss of Rs 10 per share (Rs 100 – 110) X 1000 shares = Rs 10,000. The net profit for you will be Rs 10,000.
Now, suppose the share price of company ‘A’ on expiry is Rs 90 (spot and futures). In the cash market you will make a loss of Rs 10 per share (Rs 90 -100) X 1,000 shares = Rs 10,000. In the futures market you will make a profit of Rs 20 per share (Rs 110 – 90) X 1,000 = Rs 20,000.
As you can see in the above example, you can profit whether the share price moves up or down.
Benefits and features of an Arbitrage Fund
- Arbitrage Mutual Funds enable investors to earn short term returns by taking minimal risks
- Arbitrage Mutual Funds offer investors high liquidity and better returns than savings bank account. Most of the Arbitrage Mutual Funds does not charge exit loads for redemptions after 7 - 30 days of investment.
- Arbitrage Mutual funds can give good short term returns in volatile markets which is comparable or even higher than liquid funds and ultra-short term mutual funds
- Investors should be prepared for very short term volatility before expiry of futures contract (last Thursday of every month). Sometimes the fund manager may find better divergence between spot and futures price in later monthly series relative to current month series of F&O contracts; which implies that the investor may have to wait a little (two or three months) longer.
Did you know which are the top performing Arbitrage Mutual Funds
Arbitrage Mutual Funds are ideal for investors who have funds lying idle in savings bank account for a few months as these funds can give higher returns than savings bank interest rates.
Arbitrage mutual funds are treated as equity funds from a taxation perspective. Short term (redemptions within a year from the date of investment) capital gains are taxed at 15%. Long term (holding period of more than 1 year) is totally tax free. Dividends paid or reinvested are also tax free.