Arbitrage funds can be difficult to understand. This blog contains a simple explanation of how an arbitrage fund works. We’ll also look at the returns generated by an arbitrage fund compared to other mutual funds.
January 11, 2021
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Products are valued differently in different markets. The price difference across markets & geographies can be used to generate profit. That’s the underlying principle of an arbitrage fund.
Let’s simplify arbitrage funds and tell you how the fund works to deliver returns for its investors. Along the way, we’ll also take a look at what “arbitrage opportunities” mean.
Read on till the end of the blog to see the arbitrage funds currently being recommended by Cube Wealth’s Mutual Fund Advisor, Wealth First.
Let’s begin by answering the question, what is an arbitrage fund?
What Is An Arbitrage Fund?
An arbitrage fund is theoretically a hybrid or balanced fund. This implies that an arbitrage fund invests in both debt and equity. But equity investments represent at least 65% of the fund’s portfolio.
Arbitrage funds leverage stock price differentials to generate returns. This is known as an arbitrage opportunity. Usually, the stock price differential is very low so the fund manager has to trade frequently.
How Does An Arbitrage Fund Work?
There are two primary avenues that offer arbitrage opportunities. Let’s look at each avenue in more detail.
Arbitrage Opportunity #1: Spot And Futures Markets
The fund manager may buy stocks in the spot market and sell them on the futures or derivatives market for a profit.
The spot market (cash market) is the regular stock market where you buy stocks based on the present cash value of the share. For example, the price you’ll have to pay for a TCS share is ₹3,182*.
The futures market functions on the futuristic or forecasted price of a stock. It involves a futures contract that dictates when the stock will be sold after reaching a certain value.
The stock won’t change hands immediately. It will only be transferred on the maturity date. For example, a fund manager may buy a share for ₹1000 and sell it on the futures market at an agreed price of ₹1050.
Arbitrage Opportunity #2: Different Stock Exchanges
Different stock markets offer arbitrage opportunities as well. The fund manager may buy a stock on the Madras stock exchange at ₹990 and sell it on the Bombay stock exchange for ₹1010.
The ₹20 price differential is the return that you’ll receive. Notice that the price differential is fairly low in each case so the fund manager has to trade multiple times to generate higher returns.
Arbitrage funds have a comparatively high expense ratio due to the heavy reliance on the fund manager. At the same time, they deliver moderate long term returns between 4 to 7%.
2. Invests in both equity and debt (primarily in equity)
3. Simultaneously buys and sells stocks in different markets
4. Treated as an equity fund during taxation
5. Relies heavily on the fund manager’s intuitiveness
6. Returns earned are based on the price differential
Here’s why you should never pick mutual funds on your own
Benefits And Risks Of Arbitrage Funds
Minimal arbitrage opportunities
Taxed like equity funds
High expense ratio
Arbitrage Funds Vs Other Mutual Funds
Fund Type vs Average Returns
Large-cap Funds (Equity)
Banking and PSU Fund (Debt)
Note: All facts & figures are as of 11-01-2021. Figures mentioned in the table above comprise publicly available data on Google. While we update our blogs regularly, check the Cube Wealth app for the latest facts & figures.
Top 2 Best Arbitrage Funds Of 2021 Currently Being Recommended On The Cube Wealth App
Cube’s mutual fund advisor, Wealth First, curates a list of the best arbitrage funds for Cube users every month. Here’s a snippet of the list of the best arbitrage funds:
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