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Why Arbitrage Funds are favorites among investor for a decade?

Why Arbitrage Funds are favorites among investor for a decade?
Mutualfund | May 08, 2020

Lets dig in arbitrage fund by understanding their Key Benefits.

-          Arbitrage funds rank high in pecking order when it comes to safety of capital. The objective of the fund is to create market neutral position by buying a stock in cash market and selling it in future market at same time.

-          The equity market neutral investment approach of the fund makes it qualify for equity fund like taxation which is much lower than the debt fund taxation with comparable safety of capital.

-          Arbitrage funds perform better in volatile market conditions.

In last couple of years the arbitrage fund became a one of the most popular options among the investor as an option for low risk investment due to its market neutral investment approach along with tax efficient returns on investments. Even in past couple of years the corporate treasuries in India invested in these funds as an better alternative to liquid/ ultra short term fund ( on risk parameters ) for tax efficient returns due to its equity taxation and lower risk. The average category rolling period returns for one year holding period are always positive.

Rolling Returns of Arbitrage Funds

Aditya Birla Sun Life Arbitrage Fund

ICICI Prudential Equity - Arbitrage Fund

Nippon India Arbitrage Fund

Kotak Equity Arbitrage Fund

HDFC Arbitrage Fund

Arbitrage funds try to exploit the difference between the cash and derivative segment of the equity markets for the same stock. The strategy of arbitrage fund is to pocket the price difference of stock by creating buy and sell positions in cash and future market simultaneously.

For example, if any stock is trading at Rs. 1000 in the cash market and the one-month future of same stock trades at Rs.1020 at the same time. The arbitrage fund in such case will try to reap the price benefit by buying the same stock in cash market for Rs. 1000 and selling one month stock future of same stock for Rs. 1020 at same time to create market neutral position. On the day of expiry (a future contract maturity day) the price of stock in cash market and future market will intersect.

Let’s understand the Scenario I on day of expiry in cash and future of the stock. The price of stock in cash market (settlement price of the stock) is 1030 then the profit in cash market will be Rs. 30 since the purchase price of stock was Rs. 1000 but in future market there will be a loss of Rs. 10 since the selling price of stock future was Rs. 1020. In this trade there is a profit of Rs. 30 from the stock which was purchased in cash market (  Rs. 1030 – Rs.1000 = Rs. 30) and loss of Rs. 10 from selling of stock future ( Rs. 1020 – Rs. 1030 = minus Rs. 10 ). Hence the profit from the trade will be Rs. 20 ( Rs. 30 Gain from Cash plus loss of Rs. 10 from Future trade ).

In another Scenario II if the cash price of stock on expiry is Rs. 990 then there will be loss of Rs. 10 in stock cash price since we bought stock for Rs. 1000 and the stock future position of stock will make Rs. 30 since we sold the future at Rs. 1020 and now it is getting settled at Rs. 990. The net gain in this trade will be Rs. 20 after adjusting the loss of cash position of Rs. 10 against the profit of Rs.  30 in future position.

Generally there are better arbitrage opportunities in volatile market conditions. Most of the Arbitrage funds in India create a trade setup in one month future contract which the keep on rolling every month for better liquidity. In volatile market conditions the fund managers try to exploit the opportunities to reap the profit from the trade before its expiry and reinvest in another trade. The volatility in equity market creates many such churning opportunities for arbitrage funds compared to the stable market conditions.

The arbitrage funds irrespective of its investments in equity and equity derivatives are independent of risk associated with equity market due to its market neutral positions in cash and future market. Although there may be a interim volatility in fund NAV ( Net Asset Value ) before the expiry due to marked to market of positions held in cash and future market but this gets ironed out once the positions are closed with targeted profit at the time of trade set-up. These trades generally gets squared off on expiry or very near to expiry or at the time of any profit booking opportunities available to avoid any impact cost on NAV ( Net Asset Value ) of the fund.

It is always advisable to invest in Arbitrage funds with investment horizon of 3 Months to 6 Months.

Pawan MeharFounder, FundValiz

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Mutual fund investments are subject to market risk. Please read the scheme information and the related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements before choosing a fund, or designing a portfolio that suits your needs.

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