Best Arbitrage Funds: How do they work?
To explain what arbitrage funds are and how they work, try answering this question:
Would you like to buy or sell the same asset at different prices from different countries, regions, markets, commodity or exchange? And, thus, make the most of the price difference.
As an investor, you would prefer to buy at a low cost but wait to redeem it until it gives you your expected return, right?
The Arbitrage fund works on a simple matrix of buying low and selling high.
Arbitrage works by going long on the asset in the market or segment where the price is low and going short in the market or segment where the price is high.
Although the price differences may seem small or minuscule to the layperson, even these tiny differences can make a lot of difference to your returns.
Choosing an Arbitrage Fund
Here are some of the essential elements to look for while choosing arbitrage funds:
- Since these are hybrid funds, you can look for the right proportion of the debt and equity components as per current market conditions.
- Consistency in terms of returns
- Downside protection
- Performance in comparison to similar funds
Common Arbitrage Investments
One of the popular strategies performed by arbitrage fund managers is buying in the cash market and selling in the futures market. They can do this if the price of the futures is higher than the price of the stock in the cash market.
Similarly, if the price of the futures is less than the cash price, the fund manager might buy the futures and sell the stock in the cash market.
Understanding Arbitrage with an Example
Let’s say the price of a listed stock, X is ₹1000 in the cash stock market, and the price of X in the futures market is ₹1010.
The arbitrage fund manager can buy or go long on X in the cash market and sell or go short on X in the futures market.
At the end of the month, when the prices of both the stock and the futures converge, the fund manager can derive a profit of ₹10 by settling the futures position.
Now consider that the price of the X’s futures is ₹990, the current price is ₹1000. If the fund manager feels that the price can fall, then going long on the futures market and short on the cash market might result in a profit. At the end of the
month, when the prices converge, there can be ₹10 profit.
In both cases, the risk is somewhat lower than equity-based funds.
Now you know what are arbitrage funds and how they can help in effectively mitigating the volatility risk. Returns from these funds can be directly proportional to the volatility in the market.
Since these funds take advantage of price movements in the short term, a suitable investment horizon for these funds can be around 1 year. Therefore, if you wish to generate low-risk returns over this period, you can invest in arbitrage funds.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully