Arbitrage funds are another variation of mutual funds but are taxed like equity funds. In arbitrage funds, the gains are unpredictable, even if they are relatively low risk funds.
An arbitrage fund buys stocks in the spot market and simultaneously sells that interest in the futures market.
S. Ravi, former president of the Bombay Stock Exchange, founder and managing partner of Ravi Rajan & Co. says: “They operate by exploiting the price differential between assets that should theoretically be priced the same. The differences between stock prices and futures contracts are generally small. Arbitrage funds have to execute a large number of trades each year to achieve substantial gains. “
What are arbitrage funds?
According to industry experts, the spot price of a stock, also known as the spot price, is what most people think of as the stock market. For example, suppose the spot price of a stock is at the going market price, then one can buy a stock for its value and own that part of the company when the trade is executed. A company’s stock could sell for 20 a share today, but the majority of investors might think the company is poised for a peak next month. In this case, a futures contract with an expiration date one month later can be valued much more highly. The difference between the spot price and the futures price of the ABC stock is called the arbitrage profit. Arbitration funds benefit from these different rates. They buy stocks in the spot market and simultaneously sell a contract in the futures market if the market is bullish on the stocks.
Ravi adds, “If the market is bearish, arbitrage funds buy the cheapest futures contracts and sell stocks in the spot market for the current highest price. Arbitrage funds can also profit from trading stocks on different exchanges. They could be bought on one exchange at a certain price and sold on another exchange at a higher price.
Advantages of arbitrage funds
Arbitrage funds offer multiple advantages – experts say these first include low risk as each security is bought and sold simultaneously; there is virtually no risk associated with long-term investments. Arbitrage funds also invest a portion of their capital in debt securities, which are generally considered to be very stable. When there is a shortage of profitable arbitrage transactions, the fund invests more in debt. This makes this type of fund very attractive to investors with a low tolerance for risk.
Ravi says, “Another big advantage of arbitrage funds is that they are one of the only low risk securities that thrive when the market is very volatile. This is because volatility leads to uncertainty among investors. The differential between the spot and futures markets increases when prices are volatile. A very stable market means that the prices of individual stocks do not show much change. When the markets are calm, investors have no reason to believe that stock prices in a month will be much different from current prices. Volatility and risk go hand in hand.
Who should invest in arbitrage funds?
Industry experts say arbitrage funds are a good choice for cautious investors who want to profit from a volatile market without taking too much risk. Second, they are taxed like equity funds.
Ravi says, “Arbitrage funds are technically balanced or hybrid funds because they invest in both debt and stocks, but they invest primarily in stocks. Therefore, they are taxed like equity funds since long stocks represent on average at least 65% of the portfolio.
Thus, as an investor, if you hold your shares in an arbitrage fund for more than a year, the gains received are taxed at the capital gains rate. This rate is much lower than the ordinary rate of income tax.
He further adds: “Arbitrage funds are suitable for investors who are looking to gain exposure to equities but are concerned about the risk associated with it. Arbitrage funds are a safe option for risk averse people to safely park their excess funds in the event of persistent market fluctuation. “
Disadvantages of arbitrage funds
One of the downsides of arbitrage funds is the unpredictability of earnings. Experts say that one of the main drawbacks of arbitrage funds is their poor reliability. Ravi says: “Arbitrage funds are not very profitable in stable markets. If there are not enough profitable arbitrage trades available, the fund can essentially become a bond fund, albeit temporarily. Excessive time in bonds can drastically reduce the profitability of the fund, so actively managed equity funds tend to outperform arbitrage funds over the long term.
Plus, they have high expense ratios. The high number of trades required by successful arbitrage funds means that their expense ratios can be quite high. Experts say that while arbitrage funds can be a very lucrative investment, especially during times of heightened volatility, their insufficient reliability and high expenses indicate that they shouldn’t be the only type of investment in a company. wallet.