Arbitrage funds are a type of mutual fund that aims to generate returns by exploiting price differences in various markets. In simple terms, they take advantage of price discrepancies between the cash (spot) and futures markets for stocks. These funds are a popular choice for investors looking for low-risk opportunities to earn stable returns, particularly in volatile markets.
How Do Arbitrage Funds Work?
Arbitrage funds mainly function by identifying price mismatches. Like, a stock might be available at a lower price in the cash market (spot market) than in the futures market. Arbitrageurs can buy the stock in the cash market and simultaneously sell it in the futures market. This locks in the price difference as profit.
Because the fund is protected by simultaneously taking opposite positions in both the cash and futures markets. Thus, the risk involved is lower compared to other investment strategies. This makes arbitrage funds an attractive option for conservative investors looking for relatively safer returns.
Why Choose Arbitrage Funds?
- Low Risk: Since arbitrage funds exploit price differences in markets that usually exist for a short time, they are considered relatively low-risk compared to other equity-based funds.
- Stable Returns: These funds aim to provide steady returns, even when markets are volatile. While returns may not be extremely high, they tend to be consistent.
- Suitable for Conservative Investors: Investors who are risk-averse but still want exposure to the equity markets often prefer arbitrage funds.
Example of Arbitrage Fund Strategy:
Let’s say you notice that the price of stock XYZ is ₹1,000 in the cash market, but in the futures market, it is ₹1,100. An arbitrage fund would buy stock XYZ in the cash market for ₹1,000 and sell the same stock in the futures market for ₹1,100. The difference of ₹100 is the potential profit the fund makes, minus any transaction costs.
Even though the price difference might seem small, when done on a large scale, it can lead to significant returns. Furthermore, since the positions in both markets are hedged, the risk of loss is minimal. This makes this strategy attractive for investors who prefer lower-risk investments.
Risks of Arbitrage Funds:
- Market Risk: If there is a sudden change in the stock’s price or market conditions, the arbitrage opportunity may disappear, leading to reduced profits or even losses.
- Liquidity Risk: In certain market conditions, it may become difficult to execute trades at the expected prices, especially in low-volume stocks or during high volatility.
- Interest Rate Risk: Arbitrage funds often borrow funds to make trades. If interest rates rise unexpectedly, it can affect the profitability of these funds.
- Tracking Errors: The fund may not always be able to perfectly capture the price differences between the spot and futures markets, leading to smaller returns than anticipated.
Conclusion:
Arbitrage funds are a great option for investors who want to earn moderate returns with relatively low risk. They take advantage of small market inefficiencies and deliver consistent, albeit lower, returns. While not suitable for aggressive growth, these funds are ideal for conservative investors looking for safer, stable income.
– Ketaki Dandekar (Team Arthology)
Read more about Arbitrage Funds here – https://groww.in/arbitrage