Arbitrage Funds: Meaning, Benefits, Examples, How They Work

Arbitrage funds are investment vehicles capitalising on price discrepancies or mispricing in financial markets. They employ a unique strategy of simultaneously buying and selling related assets to profit from the price difference. These funds are designed to offer stable returns and lower-risk investments, making them attractive to investors. In this blog, we will discuss arbitrage funds, how they work, different types of arbitrage funds, risks to consider, and performance expectations.

Content

• What are Arbitrage Funds?
• How Do Arbitrage Funds Work?
• Example - Arbitrage Funds
• Benefits of Arbitrage Funds
• Risks Involved in Arbitrage Funds
• Top Arbitrage Funds in India

Before we learn about arbitrage funds, let us understand what arbitrage is.

So, arbitrage is an opportunity to generate wealth by finding a price difference of the same security between markets and capitalising on it. Let us understand this through a simple example. A colleague of yours is looking for a bottle of old wine at a steep price but cannot find it anywhere. You somehow saw the same bottle of wine, priced lower than your colleague mentioned. You got an idea, purchased one bottle of that wine at a cheaper cost, and sold it to your colleague at the price he mentioned for a quick profit. 

That is essentially the game of arbitrage, but in the financial markets, this game becomes more complex. Spotting these price discrepancies across exchanges or between futures and cash markets requires eagle eyes, extensive research, and an understanding of market dynamics. It's not for everyone.

This is where Arbitrage Funds come into play.

What are Arbitrage Funds?

Arbitrage funds are a type of mutual fund that aims to exploit price discrepancies between the same or similar securities in different markets. They do this by simultaneously buying the security in the market where it is cheaper and selling it in the market where it is more expensive. This is risk-free profit, as the fund can make money if the price difference exists.

How Do Arbitrage Funds Work?

Here's how arbitrage funds work:

Identifying Price Differences

Arbitrage funds primarily look for price differences or mispricing between two related assets or markets. These assets include stocks, commodities, currencies, or other financial instruments. The key is that these assets should have a correlation or connection.

Buying Low, Selling High

The fund managers keep a hawk-eye on markets, searching for assets with "mispricing." This could be the same stock trading at different prices on two exchanges or a futures contract priced differently than the underlying asset. They analyse the connection between these assets and understand why the discrepancy exists. Once they identify an opportunity, the fund takes advantage of it quickly. They simultaneously:

• Buy the "undervalued" asset (trading at a lower price).
• Sell the "overvalued" asset (trading at a higher price).

Locking in the Price Difference

After buying the undervalued asset and selling the overvalued asset, the fund locks in the price difference. This means that the fund has established a position designed to profit from the convergence of prices between the two assets.

Monitoring and Management

Arbitrage fund managers continually monitor their established positions. They closely monitor market conditions, news, and price convergence factors. They are also prepared to adjust their positions or exit the arbitrage trade if necessary.

Profit Generation

The primary source of profit for arbitrage funds comes from the price difference between the assets they've bought and sold. As these prices converge, the fund makes a profit through capital gains, dividends, or interest income, depending on the nature of the assets involved.

Points to Remember

• Arbitrage funds aim for low-risk, steady returns by exploiting short-term discrepancies, not predicting market trends.
• Their approach usually leads to smaller but consistent profits compared to high-risk investments.
• Arbitrage funds require skilled fund managers to identify and capitalise on quick price gaps.

Example - Arbitrage Funds

Let us take an example of three investors who are entering the investment markets with similar funds, but the investment vehicles are different. In this example, we will calculate how much each investor will gain at the end of the investment period -

Assumptions:

We have three investors who plan to invest Rs. 20 lakh each.

• Investor 1 invests in a bank fixed deposit, which pays an interest of 4.5%.
• Investor 2 invests in an arbitrage fund.
• Investor 3 invests in a debt fund.

All three investors are in a 30% tax bracket, except for arbitrage funds, which have a 15% tax rate. To calculate the tax advantage in an arbitrage fund compared to other investment options, we need to consider the tax implications of each investment for the three investors. Let's break down the calculations for each investor.

Investor 1 (Bank FD):

Investment Amount: Rs. 20 lakh

Interest Rate: 4.5%

Interest Income: 4.5% of 20,00,000 = Rs. 90,000

Tax on Interest Income: 30% of Rs. 90,000 = Rs. 27,000

Investor 2 (Arbitrage Fund):

Investment Amount: Rs. 20 lakh

Arbitrage funds are treated as equity funds for taxation.

Assuming Capital Gains: Rs. 2 lakh (for illustration purposes)

Long-term capital gains tax on equity funds is 15% on gains exceeding Rs. 1 lakh.

Investor 3 (Debt Fund):

Investment Amount: Rs. 20 lakh

Assuming Debt Fund Interest Rate: 6% 

Interest Income: 20,00,000 * 6% = Rs. 1,20,000

Tax on Interest Income: Rs. 1,20,000 * 30% = Rs. 36,000

Tax on Capital Gains:

Capital Gains: Rs. 2,00,000

Taxable Capital Gains: Rs. 2,00,000 - Rs. 1,00,000 (exemption) = Rs. 1,00,000

Long-term Capital Gains Tax: Rs. 1,00,000 * 15% = Rs. 15,000

Now, let's calculate the tax advantage of Investor 2 (arbitrage fund) compared to Investor 1 (bank FD) and Investor 3 (debt fund):

Tax Advantage of Arbitrage Fund (Investor 2) over Bank FD (Investor 1):

Tax paid by Investor 1 (Bank FD) = Rs. 27,000

Tax paid by Investor 2 (Arbitrage Fund) = Rs. 15,000

Tax Advantage = Tax paid by Investor 1 - Tax paid by Investor 2 = Rs. 27,000 - Rs. 15,000 = Rs. 12,000

Tax Advantage of Arbitrage Fund (Investor 2) over Debt Fund (Investor 3):

Tax paid by Investor 3 (Debt Fund) = Rs. 36,000

Tax paid by Investor 2 (Arbitrage Fund) = Rs. 15,000

Tax paid by Investor 3 - Tax paid by Investor 2 

=> Rs. 36,000 - Rs. 15,000 = Rs. 21,000

So, Investor 2 (Arbitrage Fund) enjoys a tax advantage of Rs. 12,000 compared to Investor 1 (Bank FD) and a tax advantage of Rs. 21,000 compared to Investor 3 (Debt Fund) due to the lower tax rate* on long-term capital gains in arbitrage funds. 

*Please note that actual returns and tax rates may vary, and it's essential to consult a tax advisor or financial expert for personalised advice.

Benefits of Arbitrage Funds

Listed are some remarkable benefits of the arbitrage funds -

 

1. Low-Risk Strategy: Arbitrage funds minimise risk by exploiting minor price differences between similar assets in different markets. They don't rely on the direction of the overall market; instead, they seek to exploit short-term inefficiencies in pricing. Arbitrage funds aim to provide stable returns even in volatile market conditions. Arbitrage funds are designed to minimise market risk since they simultaneously hold long (buy) and short (sell) positions.
2. Holding Period: The holding period for arbitrage funds can vary but is generally short-term. Depending on the specific arbitrage opportunities and market conditions, these funds may hold positions for several days to a few weeks.
3. Returns: The returns generated by arbitrage funds primarily come from the price differences between their trade assets. These returns may be in the form of capital gains and dividends.
4. Tax Advantage: In many countries, arbitrage funds may enjoy a lower tax rate on long-term capital gains than traditional equity funds. This tax advantage can make them attractive to investors.
5. Portfolio Diversification: Arbitrage funds enhance portfolio diversification by offering a strategy independent of market direction. Their low correlation with traditional asset classes helps spread risk and improve overall portfolio performance.

Please note that arbitrage funds are generally considered lower-risk investments but are not risk-free. There's always the possibility that the expected price difference between assets may not materialise as anticipated, which could lead to lower returns or even losses. Additionally, the returns from arbitrage funds are typically lower than other high-risk/high-return investment options.

What Are the Risks Involved in Arbitrage Funds?

Though arbitrage funds come with low risks, there are certain key considerations when investing in arbitrage funds:

• Arbitrage strategies can be affected by market fluctuations, potentially impacting returns.
• Some arbitrage opportunities may not be easy to enter or exit swiftly, affecting investment flexibility.
• Alterations in regulations or tax laws can influence the effectiveness and efficiency of arbitrage strategies.
• In certain arbitrage scenarios, there may be dependence on other parties to fulfil obligations, introducing potential risks.
• Increased competition in the arbitrage space can reduce profit opportunities over time.
• Extreme market conditions can lead to higher-than-expected volatility.

Top Arbitrage Funds in India

Below are India's top arbitrage funds as of December 19, 2023.

Fund Name	Expense Ratio (%)	1-Year Return (%)	3-Year Return (%)	5-Year Return (%)
Invesco India Arbitrage Fund	0.68	3.89	5.58	7.25
Tata Arbitrage Fund	0.67	3.70	5.09	6.89
Edelweiss Arbitrage Fund	0.64	4.25	5.82	7.72
Kotak Equity Arbitrage Fund	0.67	4.02	5.30	7.06
Nippon India Arbitrage Fund	0.64	3.77	5.15	6.93
Axis Arbitrage Fund	0.68	3.58	4.98	6.65
ICICI Prudential Equity Arbitrage Fund	0.75	3.28	4.61	6.29
SBI Arbitrage Opportunities Fund	0.69	3.19	4.45	6.11

Consider your investment goals, risk tolerance, and investment horizon before choosing an arbitrage fund or any mutual fund. To get the best out of these funds, check the latest performance, expense ratios, and other details for these funds, as well as any new funds that may have been introduced.

Conclusion

Arbitrage funds offer a unique and effective way to invest in the financial markets, capitalising on price discrepancies to provide stable returns with lower risk. Investors must remember that even though arbitrage funds are considered low-risk, they are not entirely risk-free, and returns may be more modest than higher-risk investments. Before investing, individuals should carefully assess their financial goals, risk tolerance, and investment horizon.