How these funds work for investors looking at relatively high returns in volatile conditions
Arbitrage involves simultaneous purchase and sale of identical or equivalent instruments from two or more markets to benefit from a discrepancy in their prices. In arbitrage strategies, the buying and selling transactions offset each other thus building in immunity to market movements. So, regardless of stock market fluctuations, the fund will not get impacted.
The profit in arbitrage strategy is the difference between the prices of the instrument in different markets. For example, cash and derivative markets. Though arbitrage funds are relatively less risky as compared to pure equity, they do have an element of risk.
Arbitrage opportunities are good if the market is volatile. Arbitrage funds perform best in a volatile market. The higher the volatility, greater the arbitrage opportunity. Such funds are better-suited for investors who want low risk profile funds but expect decent returns. Fund managers hedge their risks by going long in the cash market and short in the futures market. These are safer as they always hold hedge positions and switch between cash and the futures options. Their risk profile is lower and regardless of market movement, the returns are good. Arbitrage funds are supposed to be market-neutral. Their return-potential depends on the arbitrage opportunities.
One strategy includes buying stocks and selling futures. This arises when the price of a share trades at discount to the price of its future contract. Thus, one can buy the stock from the cash market at lower price and sell its future contract at a higher price, the profit being the difference between the future price and cash price. On or before the expiry date, the difference between the spot and futures price narrows. The position is then unwound to book profits. This happened in a few recent follow on public offers (FPOs).
Not quite risk-free
Though arbitrage funds are referred to as 'risk-free' investments, this is not strictly true because there is some risk in availability of arbitrage opportunities and their timing. Arbitrage funds depend heavily on the availability of arbitrage opportunities in the market. A long bear phase may create problems because the arbitrage strategy of buy stock, sell future will not work if the future price of the stock is trading at a discount to its spot price.
On the date of expiry, when the arbitrage is to be unwound, the stock price and its future contract may not coincide. There could be a discrepancy in their prices. Thus, there is a possibility that the arbitrage strategy gets unwound at different prices, leading to a higher or lower return. In addition to scarce arbitrage opportunities, margins tend to be low and expense ratios high as such funds trade heavily. Arbitrage funds are also impacted by lower liquidity in the spot/future segment.
Future contracts are always traded in lots i.e. one lot of a future contract of a particular stock will have multiple shares. If an arbitrage opportunity arises, the fund manager will have to buy the lot shares of the company from the stock market and sell one lot of its future contract. The fund manager may not be able to purchase the desired number of shares at the given price.
Liquidity crisis
Future contracts usually get squared-off automatically at the expiry date. But shares bought as part of the arbitrage strategy have to be sold before the market closes on the expiry date. If there isn't adequate liquidity in that stock, and all the stocks bought against its future contracts cannot be sold, it may cause losses. At the same time, the short position on its future contract must be squared-off, as it cannot be carried forward to the next month because of lack of opportunity.
Tax angle
Since these funds are largely invested in equity, arbitrage funds attract a short-term capital gains tax of 15 percent. But if you hold it for more than a year, you are not liable to pay any tax. For tax purposes, arbitrage funds are treated as equity funds and enjoy lower tax vis-a-vis debt funds.
