Mutual funds are popular investments. We all have invested in mutual funds in one way or another. They give investors exposure to a wide variety of assets by pooling together money from different investors and purchasing stocks, bonds, and other securities. Funds are managed by portfolio or money managers who try to generate gains or income for their investors. Fund portfolios are designed to match their goals and objectives.
You all must have question what is arbitrage funds? Is it a mutual fund? If yes... then how it works? So scroll, read and learn.
Arbitrage mutual funds are a type of investment fund that aims to make money by exploiting price differences of the same or similar securities in different markets. In simpler terms, these funds buy and sell the same assets in different markets or forms to take advantage of price differences and make a profit. Let’s say, a fund purchased stock in the cash market and sell that in the futures market with higher price in less time. It is appeal to investors who want to profit from volatile markets without taking on too much risk. Sounds good right?
Now, you all must wondering how does these funds works?
Let's look at the two possible scenarios where arbitrage opportunities exist:
Scenario 1: Price Difference between Exchanges
Let's say that the stock of XYZ Limited is selling at Rs. 1000 per share on the Bombay Stock Exchange (BSE) and at Rs. 1010 per share on the National Stock Exchange (NSE).
If the fund manager of an arbitrage fund spots this opportunity, then he buys shares from the BSE and simultaneously sells them on the NSE. This allows him to make a profit of Rs. 10 per share (less transaction costs) without any risks.
Scenario 2: The Price Difference between the Cash and Futures Markets
Let's say that the share of XYZ Limited trades at Rs. 1000 in the cash market and Rs. 1015 in the futures market. The fund manager of the arbitrage fund buys shares from the cash market and creates a futures contract to sell the shares at Rs. 1015. At the end of the month, he sells the shares in the futures market and books a profit of Rs. 15 per share (less transaction costs) without taking any risks.
While arbitrage mutual funds can offer profitable or higher returns, they are not without their challenges. Let us look into the benefits & risks of funds:
- Benefits:
- Lower Risk:
Since arbitrage involves exploiting price inefficiencies rather than predicting market movements, these funds are generally considered lower risk compared to traditional equity or bond funds.
- Steady Returns:
The goal of arbitrage mutual funds is to provide consistent, albeit modest, returns. This can be appealing for investors looking for stability rather than high volatility.
- Diversification:
Arbitrage funds often employ various strategies and trades, which can provide diversification within the fund itself. This diversification can reduce the overall risk of the fund.
- Risks
- Market Conditions:
Arbitrage opportunities can diminish in highly efficient markets where price discrepancies are quickly corrected.
- Transaction Costs:
Frequent trading to exploit price differences can lead to higher transaction costs, which may affect the fund’s net returns.
- Complex Strategies:
The strategies used by arbitrage funds can be complex and require sophisticated risk management. It’s important for investors to understand the specific strategies employed by the fund.
- Potential for Lower Returns:
Given their lower risk profile, the returns on arbitrage mutual funds might be lower compared to more aggressive investment strategies.
There's probably a very good chance that you haven't heard of arbitrage funds. That's because they aren't like your typical mutual funds. Unlike other funds, arbitrage funds place large orders and capitalize on price differentials for the same security in different markets. This allows investors to profit from market volatility without taking on too much risk. This is only one of the many types of investing in arbitrage. However, like all investments, it’s crucial to understand the underlying strategies, risks, and costs associated with these funds.
