What is Arbitrage Fund?
An Arbitrage Fund is a hybrid mutual fund that generates returns by buying and selling securities from different markets. These Funds also can invest in debt and money market securities. The fund generates profits by leveraging price differences between different capital markets.
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The investor purchases securities at a lower price and sells them when the price goes up in another market. Through arbitrage, investors make risk-free profits. Arbitrage funds are referred to as hybrid mutual funds because they invest in a combination of equity and debt funds. In comparison, liquid funds, for example, invest only in debt instruments.
Table of contents
- Arbitrage Fund Meaning
- How Does Arbitrage Funds Work?
- Examples
- Taxation
- Benefits
- Arbitrage Funds vs Liquid Funds
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- An arbitrage fund is a hybrid mutual fund that generates returns by leveraging price differences between different financial markets.
- These funds are taxed as capital gains. But there is a caveat. The portfolio must contain a minimum of 65% equity funds; the remainder can be debt.
- The value of the shares is not dependent on the current asset prices in the futures market. Instead, the value depends on the future price of the underlying asset. This leads to price variations, and arbitrageurs leverage it.
How Does Arbitrage Funds Work?
Arbitrage mutual funds take advantage of the price variation in different market segments–for the same underlying security. For example, at a given time, the price of a security in the spot market is $5000, and the price of the same security is $5,500 in the futures market. In such a scenario, a fund manager can buy the security at $5000 from the spot market and sell it in the future market for $5,500. By doing so, the asset manager can make a profit of $500.
The security price varies; because the share’s value in the futures market does not depend on current asset prices. Instead, the value depends on the future price of the underlying asset.
Investors and managers undertaking such trades are often referred to as arbitrageurs. Arbitrageurs purchase financial assets from a market at a lower price and sell them in a different market at a higher price. Arbitrageurs are earning risk-free gains by capitalizing on the inefficiencies of the financial market.
These traders also take advantage of private information concerning a company to make financial gains. For example, if a trader has information regarding an impending acquisition, they may buy shares of the organization to profit from the future price increase.
Examples
Let us look at the arbitrage fund examples to understand the concept better.
Example #1
The shares of Amacon company are valued at $3000 on the London Stock Exchange. The same shares traded on The New York Stock Exchange at $3200. The asset manager spots the price differences in both the market and buys from the London Stock Exchange at $3000 and sells it on the New York Stock Exchange for $3200. The arbitrageur just made a risk-free profit of $200.
Example #2
Amacon company shares are trading at $2300 in the spot market. The same shares trade at $2500 in the futures market. The arbitrage fund manager buys the share for $2300 from the spot market and drafts a contract to sell it in the future market at $2500. At the end of the month, the fund manager books a risk-free profit of $200 on each Amacon share.
Taxation
Let us look at arbitrage fund taxation.
The increase in the net asset value of an arbitrage fund is generally considered a capital gain. Arbitrage funds are considered hybrid; they invest in equity and debt. The portfolio must contain at least 65% equity funds. The remainder could be debt.
The majority of the fund comprises equity. The returns from equity funds are classified as short-term capital gains if the investment lasts twelve months or less. But if the investment is held for longer, the returns are classified as long-term capital gains.
A taxation of up to 37% is imposed on short-term capital gains. In comparison, the tax imposed on long-term gains is lower—0%, 15%, or 20%. Thus, arbitrage fund taxation depends on the portfolio composition.
Benefits
Let us look at arbitrage fund benefits.
- Arbitrage funds are low-risk investments; the fund manager buys and sells a security at a low risk of loss. Also, the investment period usually lasts between six to twelve months.
- These funds render fewer risks compared to other hybrid equity funds.
- As long as the fund holds a minimum of 65% equity funds, they are taxed as capital gains—a set limit. As a result, long-term capital gain tax is lower than the tax imposed on ordinary income.
- Profits depend on the difference between the spot market and the futures market. The larger the variation, the larger the profits.
- These funds perform even better in volatile market conditions. Thus, investors specifically invest in arbitrage when there is instability.
Arbitrage Funds vs Liquid Funds
- Arbitrage funds are hybrid mutual funds that invest in a combination of equity and debt. In contrast, liquid funds primarily invest in the debt market.
- The former is less liquid. Individuals cannot retrieve hybrid funds in less than three to five days. In contrast, an individual can quickly convert the latter into cash.
- There is more risk associated with the former, as it involves both the debt and equity markets. There is less risk associated with the latter; investors invest predominantly in the debt market.
- The former is taxed as capital gains (short-term or long-term). In contrast, returns from the latter are taxed by the income tax slab rate.
- There is zero or low risk associated with fixed deposit investment. In contrast, the risk is higher with arbitrage funds; price fluctuations depend on the market price.
Frequently Asked Questions (FAQs)
These funds are called hybrid mutual funds because they buy and sell securities from equity and debt markets. But there is a limit; the portfolio must contain a minimum of 65% equity funds. The remainder can be debt.
These funds are superior to fixed deposits (FDs) if the investor has a higher risk appetite. They offer higher returns. FDs offer the same returns irrespective of market fluctuation—it is a low-risk, low-reward option.
The spread is the difference in the securities prices in different capital markets. The larger the difference between the spot price and the futures market, the higher the expected return. Usually, investors buy shares from the spot market at a low price and sell them on the futures market at a higher price.
Recommended Articles
This has been a guide to what is Arbitrage Fund and its meaning. Here, we explain its taxation, comparison with liquid funds, examples, and benefits. You can learn more about it from the following articles –
- Regulatory Arbitrage
- Arbitrage Pricing Theory
- Merger Arbitrage
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
