Why arbitrage funds rank high when it comes to safety?

Who can assure you of the guaranteed return on your investment in the equity market? Undisputable, no expert investor in the equity market can guarantee that you will make a profit from every transaction you enter into. Therefore, those investors who do not want to take the risk go for investing in arbitrage funds which throw an opportunity for risk-free investments. This is because while the investors entering into the equity market are affected by the turbulence, the same situation has been turned into an opportunity by the arbitragers. Let us find out, how arbitrage funds take advantage of market turbulence.

Arbitrage is the technique of gaining profits by purchasing and selling shares on separate markets or exchanges at the same time.  The margin is a difference in price between two markets or exchanges for a particular security, currency, or commodity; it is also known as the arbitrageur’s profit.

In a situation of high and persistent volatility, arbitrageurs make money by taking advantage of the price differential markets, mostly between the cash and future market. For instance, the stock price of ABC Company is trading at 1000 in the spot market now, where its futures price is Rs.1025.  On the settlement day of the futures transaction, the arbitrage makes a profit of Rs.25 for every Rs.1000 invested by him in the spot market. This means the arbitrager, buys ‘ABC Company’s share’ in the cash (spot) market and makes a risk–free profit by simultaneously selling ‘ABC Company’s shares’ in the futures market. The market will continue to throw such opportunities on a regular basis and the intelligent arbitrager will make more money with the increase in market volatility. The arbitrage strategy is actually a market-neutral and low-risk business. In the above example of ‘ABC Company’s share’, you may observe, one is not affected by the movement of the stock price of ABC Company in any direction, whether the price has risen or fallen in the interim. Hence arbitrage strategy is less risky, as the arbitragers do only the paired trades, and the profit made by him is pre-determined. As these funds invest predominantly in equities, their tax treatment is at par with equity funds.

Advantages of arbitrage strategy:

No stock market risk as the buying and selling price of a stock is known to the fund manager.

A major advantage enjoyed by arbitrage funds is that of equity taxation. While profits made in debt funds held for less than 36 months are taxed as per the income tax rate of the investors, profits made in arbitrage funds held for less than 12 months (short-term capital gains) are taxed at 15% plus applicable surcharge and cess. If units of arbitrage funds are sold after 12 months from the date of purchase then profits (long-term capital gains) of up to Rs 1 lakh are tax-exempt in a financial year. Long-term capital gains in excess of Rs 1 lakh are taxed at 10% only. Thus, Equity taxation means more tax-efficient returns when compared to Fixed Deposits

Although arbitrage strategy sounds like a very simple and effective way of making money in the market, retail investors have to remember that arbitrage trading also needs some expert skill and all retail investors cannot easily do it. It is better to go for the arbitrage category of any of the leading mutual funds in India. Do remember that low-risk investment means low profit. The returns on this investment may not be as attractive as the investment in the equity market. Experts say as a category these funds have generated around 6 percent annualized returns in the recent past. This reduction in return is an effect of good historical returns generated by arbitrage funds losing their shine as too many people started chasing this small pie. When demand for an item is high-profit margin will naturally come down.

Originally posted on November 3, 2013, edited and reposted on March 18, 2023

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