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Arbitrage Mutual Fund Schemes
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In several of my discussions, i used a term called Arbitrage fund.
In most of the cases, it was referred as being a tax efficient investing method.
Is arbitrage fund safe investment ? Will this protect capital?
Let us see the definition of Arbitrage fund.
Arbitrage fund is a type of mutual fund that ..
leverages the price differential in the cash and derivatives market to generate returns.
Lets take an example:
Assume a company share is trading at Rs 1,000 in the cash market
And in futures market, they are trading at Rs 1,500.
Clearly there is a price difference.
So, Rs 500 per share is the profit an investor can make ..
by buying stock in the cash market and simultaneously selling it in the futures market.
This is exactly the fund manager does in this type of funds.
In general, such price mismatches do not stay for long time.
Particularly when algorithm and automated trading happens.
So, the fund manager should be smart and quick enough to identify such mismatches and excute the pair trade quickly.
If the trade is successfully executed, Rs 500 per share profit would come almost immediately.
So, in a way, they are safe trades.
The challenge lies in identification of such pair trades.
Hence, the returns are dependent on the volatility of the asset.
If the market is more volatile and the fund manager can spot opportunities..
he can make use of the situation to generate profit for the scheme.
These are unique schemes because they offer equity exposure with low risk.
Not all arbitrage opportunities will be profiable because..
Along with the the profit, the fund manager incurs some expenses such as brokerage charges.
So, the arbitrage opportunity should be wide enough to be profitable.
Since the scheme has a lot of corpus, the arbitrage trade should be liquid enough too..
otherwise, the fund manager would buy on one side and might not be able to sell on the other side of the market.
Hence, lot of caution, care and timing is to be used.
The returns from arbitrage funds would not be consistent.
This is because the performance of the scheme depends largely on the identification of arbitrage pair.
And of course, market conditions have to support as well.
So we cannot compare different arbitrage schemes like we do in normal sense.
Now let us see the risk aspect.
Since the cash market buy and future market sell happens almost immediately, we can say they donot have much risk.
Since the risk element in very low, we can compare them to debt funds.
From an investor perspective, Arbitrage funds are tax efficient (over debt funds).
This is because, Arbitrage funds are treated as equity schemes.
So Equity Short / Long term capital gains apply.
How to use Arbitrage funds?
1. If you are looking for a tax efficient gains of 6 to 9% per annum, you can go for these.
2. If you trade directly in equity markets and have some short term losses there, Arbitrage fund gains could be used to offset them.
3. If you want to park funds so as to route them to an equity scheme, Arbitrage funds can be your temporary scheme.
4. If you are looking for small yet risk-less monthly returns, Arbitrage funds can provide them.