Arbitrage Funds are types of mutual funds that exploit the difference of prices in the cash market and futures market by buying and selling securities on different exchanges simultaneously. The difference is very marginal, so arbitrage funds must execute a large number of trades each year to make substantial profits.
Cash market is where one can buy a share at its given rate at that particular time where as futures market is derivative and denotes the anticipated price of the stock at some point in the future. Investors analyse the trends of a stock and predict whether a stock will rise in future. They buy several shares in present from the cash market and at the same time sell the same amount of shares in the futures market when they believe the stock price must be high.
Benefits of Arbitrage Mutual Funds
- Low Risk-
These types of mutual funds are relatively low risk as the securities are bought and sold simultaneously thus eliminating the risks involved with long-term investments. Moreover, part of the capital is invested in debt securities which are highly stable. Thus, if there is a shortage of arbitrage trades that are profitable, the capital is invested heavily in debt securities and attracts investors with low-risk tolerance.
- Flourish in Volatile Market-
These mutual funds are probably the only ones that flourish in a highly volatile market and exploits the uncertainty factor. The gap between the cash and futures markets gets highly exaggerated and investors can earn greater marginal profits.
- Hybrid Fund-
Arbitrage Funds invest in both equity and debt. Since the investment is minimum 65% equity based, the taxation is done at the capital gains rate which is much lower than the ordinary income tax rate. Thus, the net gains are more.
Drawbacks of Arbitrage Mutual Funds
Due to less profitability during stable market conditions, the arbitrage funds are unreliable as they do not tend to return well. Other investments outweigh arbitrage funds in many ways.
- High Expense Ratio-
Since a large number of trades are to be performed for substantial gains, the investment is very high while the profits are comparatively marginal thus a high expense ratio. This high expense ratio points to the fact that arbitrage funds are not the types of funds that one can rely on solely, they need other investments too to uphold this one.
Despite being quite low-risk as compared to other investment options, the returns on arbitrage funds is very unpredictable and thus, investing in them should be done very thoughtfully.
On evaluating the benefits and drawbacks of arbitrage mutual funds, it is clear that though they are an easy low-risk investment option, one must not solely rely on them for profits. This should definitely not be the only option one invests in.