Volatility is a part of the market. However, most investors view market volatility as a barrier and prefer not to invest during such times. Concerns about losses, lack of control, and the fear of more market downturns ahead contribute to this aversion. Yet, experienced investors know that within this volatility lies potential for profit. A volatile market comes with challenges, but it also presents opportunities for those who can navigate it skilfully. This is where arbitrage mutual funds come into play.
What are arbitrage funds?
Arbitrage funds are equity-oriented hybrid funds that leverage arbitrage opportunities in the market. These can be pricing discrepancies between two exchanges, the spot and futures markets, etc. As per SEBI guidelines, these funds are mandated to invest at least 65% of their assets in equities and equity-related securities. The remaining portion can go into debt and debt-related securities.
Advantages of arbitrage funds
From diversification to high liquidity, there are many benefits of investing in arbitrage funds. These include:
Excel in volatile markets: Stock prices fluctuate significantly during volatility. Arbitrage funds leverage these fluctuations by buying and selling instantly in different markets. They use complex algorithms and trading techniques to carry these activities. This strategy turns market chaos into a profitable opportunity.
Tax advantages: These funds enjoy tax benefits similar to equity funds. 65% of their holdings are in equities. For investors holding these funds for more than a year, long-term capital gains tax rates apply. This aspect makes arbitrage funds more tax efficient compared to debt funds.
Less risk: These mutual funds follow a market-neutral strategy that removes directional bets on securities. Fund managers take opposite positions in the cash and derivatives market. It helps minimise risk from market movements. The primary risk involves the arbitrage opportunity closing too soon. Yet, with advanced technology and algorithms, fund managers capture pricing anomalies quickly, maintaining a low-risk profile.
A safe haven for risk-averse investors: These funds offer a low-risk alternative to conservative investors who want to have an equity portfolio but are uncomfortable with the related volatility. They provide returns that are higher than what you would get from liquid funds, all while following a market-neutral strategy. Moreover, unlike debt funds, which can be influenced by interest rate fluctuations, arbitrage funds carry lower risk. They effectively fulfil the desire for returns higher than those offered by Fixed Deposits (FDs) or savings accounts without subjecting investors to high levels of volatility.
Drawbacks or risks of arbitrage funds
No investment is entirely risk free, including arbitrage funds. The risks are:
Missed opportunities: Arbitrage funds depend on a fund manager’s skill to spot and seize price differences quickly. If the manager delays or misses these chances, the fund fails to profit.
Risk management challenges: Arbitrage involves risks from leverage and exposure. If cash and derivative positions don’t match or close at the right time, losses can occur. Strong risk management is essential.
Model risk: Fund managers use complex mathematical models to find arbitrage opportunities. If these models are flawed or ineffective, they can lead to losses. Thus, reliable model design is crucial.
Liquidity issues: Sometimes, the cash market lacks enough liquidity for the desired securities. This shortage can block the execution of arbitrage strategies and reduce profits.
It is true that adding different types of equity funds, debt securities, gold schemes in your portfolio is important. However, Arbitrage funds, being hybrid in nature and largely uncorrelated with the overall market direction, offer a new dimension to your investment strategy. Yet, the returns from these funds rely heavily on the skills of fund managers who must quickly spot and exploit minor pricing disparities. This reliance highlights the importance of evaluating a fund manager’s expertise, investment strategies, and risk control measures.