Arbitrage Funds – Meaning, Examples, Benefits, Limitations

A mutual fund that purchases and sells assets on multiple markets is refer to as a “arbitrage funds.” This is the primary objective of the fund. Due to this, people can profit from even the tiniest price fluctuations in these markets. Doesn’t this make perfect sense? Before investing in an arbitrage fund, you must understand meaning of arbitrage funds with examples, benefits and their limitations for your portfolio.

Since the fund manager simultaneously purchases and sells equities in different markets, there is no stock exposure risk. However, there aren’t many opportunities like this, and the amount of money you save is minimal. As a direct result, the returns are identical to those of the past. If you intend to keep your investment for between five and eight years, you can anticipate a return of approximately 8 percent. However, keep in mind that using arbitrage funds does not guarantee a profit.

Meaning of Arbitrage Funds

You can invest in “arbitrage funds,” which are equity-focused hybrid funds that seek to profit from arbitrage opportunities. The pricing on the spot market and the futures market demonstrate this distinction. The management of an arbitrage fund earns money by simultaneously purchasing and selling the fund’s shares.

When prices in different markets are significantly different, arbitrage funds may be able to profit. Traders can purchase shares of stock on the cash market and sell them on the futures market. This is due to the fact that the most significant types of arbitrage occur between these two markets, albeit on a smaller scale. Because of this, arbitrage funds must execute a large number of transactions annually in order to generate meaningful profits.

Examples of Arbitrage Funds

Remember that these types of funds seek to maximise profits by exploiting price disparities. If the market is bullish about a company’s stock, investors will purchase shares on the cash market and sell contracts on the futures market. Arbitrage funds purchase futures contracts at a discount and then sell the underlying stock on the cash market for more than they paid for the futures contract.

Consider the previous case study of the XYZ Company. Even if you can currently purchase a share of the company for $20, most investors believe that the price will increase by the end of the month. A futures contract with a one-month expiration date may be more advantageous in this scenario. When comparing the cash price and futures price of XYZ stock, the arbitrage profit is the difference between the two prices.

Also profitable for arbitrage funds is buying and selling equities on separate exchanges. A frequent trading approach is to purchase a stock for $57 on the NYSE and then sell it for $57.15 on the LSE, resulting in a $0.15 profit. (LSE). Depending on your investing objectives and risk tolerance, funds that invest in bonds, money markets, and long-term equities may be more consistent and trustworthy than arbitrage funds.

How Does Arbitrage Mutual Funds Work?

Consider two distinct circumstances in which arbitrage possibilities may develop. Let’s begin with the classic example of arbitrage, which occurs when the prices of two markets differ. Suppose a share of XYZ Limited costs Rs. 1000 on the Bangalore Stock Exchange (BgSE), but Rs. 1010 on the Ahmedabad Stock Exchange (Ahmedabad) (ASE). When this occurs, the manager of an arbitrage fund will purchase shares on the BgSE before selling them on the ASE. This safeguards him from potential losses and enables him to earn Rs. 10 per share in profit (after transaction fees).

Consider a second instance of this type of arbitrage in which the prices on the cash market and the futures market are distinct. On the cash market, one share of XYZ Limited costs one thousand rupees, while on the futures market, it costs one thousand and fifteen rupees. The administration of the arbitrage fund would purchase shares with cash and then establish a futures contract to sell the shares for Rs. 1015. Assuming there is no risk, he sells the shares at the end of the month on the futures market for Rs. 15 per share.

Benefits of Arbitrage Funds

The arbitrage fund attempts to profit from the price differential between two otherwise identical assets. These funds provide investors with numerous advantages, including less market volatility and a more favourable tax situation. Let’s examine these benefits of arbitrage funds.

Lowest Risk

Investing in arbitrage funds is typically regarded as a low-risk endeavour. Because they involve the simultaneous purchase and sale of all securities, long-term investments carry a very low level of risk. Arbitrage fund frequently acquire different types of debt funds securities because they appear to be very secure. If there are insufficient arbitrage opportunities, investors will instead concentrate on debt. Alternatively, this type of investment is suitable for those who dislike taking risks.

These funds may be one of the few low-risk investments that perform well during volatile market conditions, causing investors anxiety. When prices fluctuate significantly, the disparity between the cash market and the futures market grows. The market as a whole is very stable, stock prices rarely fluctuate significantly. When the market is relatively calm, investors should anticipate relatively stable stock values over the next month.

Volatility Benefits

Unpredictability and the potential for negative outcomes go hand in hand. Price volatility is required for extreme price swings in either direction. If you are a conservative investor who wants to profit in a volatile market without assuming excessive risk, an arbitrage fund may be a good option for you.

Limitations of Arbitrage Funds

This is not the same as traditional investing, in which an item is purchased with the intention of selling it for a profit in the future. Some undesirable outcomes are possible if you purchase and hold them, but these dangers are inherent to all types of investments. Here are some of the most common limitations of arbitrage funds.

High Expense Ratios

Because they trade frequently, successful arbitrage funds have high cost-to-trade ratios. This is a direct result of how effectively the funds must trade in order to succeed. To be successful, the funds must trade often.

When the market is extremely volatile, investing in an arbitrage fund could be a highly profitable strategy. Due to the unreliability and expense of these assets, however, they should not comprise the majority of your portfolio.

Make Uncertainty Profitable

It is crucial to keep in mind that one of the greatest issues with these funds is their lack of dependability. As stated previously, arbitrage funds lose money when market circumstances are easy to predict.

If there are insufficient possibilities for arbitrage, the fund can briefly behave like a bond fund. Because holding too many bonds can be detrimental to a mutual fund’s overall performance, actively managed equity funds typically outperform arbitrage funds over the whole investing horizon of a fund.

Conclusion

The “arbitrage fund” is a sort of mutual fund. If you wish to profit from a turbulent market without taking on excessive risk, you may wish to investigate these funds. Investing in arbitrage funds is not particularly dangerous, but it is difficult to predict whether the investment will be successful. The same tax laws apply to arbitrage-focused mutual funds as to equity-focused funds. Given the very high levels that expenditure ratios can reach, it is imperative for investors to keep a close eye on them.


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