Science Behind Arbitrage Trading: How Arbitrage Funds Take Advantage of Price Differences

According to many investment experts, arbitrage is a strategic way to create wealth. Arbitrage is about identifying and exploiting price differences for a particular security between two or more markets and then capitalizing on it. Being an investor, if you get the price of a particular stock to be different in the spot and futures market, then you have created an opportunity to create wealth. However, the entire process requires extensive research and understanding of how the market functions.

This article will elaborate on arbitrage funds meaning and how arbitrage funds take advantage of price differences.

What is Arbitrage?

The simultaneous purchasing and selling of a single asset in diverse markets to explore risk-free profits is known as arbitrage. For instance, a fund purchases an asset worth ₹90 in the market and sells it in market B, where it is valued at ₹100. Then, an arbitrageur can take advantage of this price difference by buying at ₹90 and selling at ₹100 simultaneously, making a ₹10 profit per unit. These profits carry minimal risks as both the purchasing and selling positions are completely hedged. In addition, as purchasing and selling are performed simultaneously, the risks involved in the movement of price may be averted.

Arbitrage Funds Meaning

Arbitrage funds are equity-oriented funds, leveraging opportunities for arbitrage in the market. These opportunities include different pricing in the futures and spot markets, matching the pricing between two exchanges, and more. The fund manager who manages the arbitrage funds purchases and sells the shares to earn the difference between the purchasing and selling price of the share.

Fundamentally, investing in an arbitrage fund is quite different from other types of investing, where you need to purchase any asset and then wait for the value of that asset to grow before you decide to sell it.

However, under an arbitrage fund, the fund manager invests in equities when he gets an appropriate opportunity to receive returns. If there are no opportunities available, investors invest in debt securities and short-term money market instruments. However, remember that the price difference is very small when purchasing and selling arbitrage funds. Therefore, you have to perform multiple trades in a day to create a reasonable profit.

Features Of Arbitrage Fund

An arbitrage fund includes the following major features:

Offers Hedge Exposure: Arbitrage funds include hedged exposures in their portfolio.
Equity-Oriented: Equity-related products and equities should account for around 65% of the portfolio.
Low-Risk Funds: These funds hold the potential to perform certain non-equity-oriented funds regarding post-tax returns.
Suited In Unstable Markets: These funds are the only low-risk investment that survives in a volatile market.

How Do Arbitrage Funds Take Advantage Of Price Differences?

Now that you know the arbitrage funds meaning, it is important to understand how they work. Arbitrage funds capitalize on the inefficiencies of price in the derivatives and cash markets. The spot market or cash market is where transactions are completed on the spot. In the future, the asset will be sold at an upcoming date at a fixed price. Hence, if a particular stock is stated at ₹100 in the cash market and ₹105 in the future market, the arbitrage fund will purchase the cash market stock and sell it in the futures market, earning a risk-free profit of ₹ 5 on the executed transaction.

Key highlights:

Arbitrage funds are capable of exploding price differences in derivatives and cash markets for low-risk returns.
These funds combine equity growth potential and hedging techniques to reduce risk.
They are highly suitable for medium and short-term investors looking to diversify their portfolios.
Arbitrage funds are taxed as equity funds and hence offer favourable tax advantages for long-term gains.

Why Invest In Arbitrage Mutual Funds?

The benefits of investing in arbitrage mutual funds are given below:

Tax Benefits: Just like equity funds, arbitrage funds also benefit from certain tax advantages. Any long-term capital gains above ₹ 1 lakh are levied with a 10% tax. However, short-term capital gains are levied with a 15% tax.
Lower Risk: Compared to traditional equity funds, these funds focus on capturing price differences between securities, eventually creating less risk. As these funds can exploit short-term efficiencies in prices, they are not so susceptible to broad market movements.
Steady Returns: Arbitrage funds are capable of offering steady returns by capitalising on the differences in prices, even when the markets are volatile. This feature makes them a perfect option for investors looking for stability in their portfolios.

Final Thoughts

Arbitrage mutual funds stand as an optimal investment option for investors looking to create a balance of risk and return mitigation. By capitalising on the inefficiencies of prices in the financial markets, arbitrage funds focus on generating profitable returns. However, investors should wisely consider their risk profile, investment horizon, tax implications, market conditions, expense ratio, fund size and the experience of the fund manager before stepping into the mutual funds investment segment.