Arbitrage Mutual Fund is a unique type of mutual fund. If i tell you that i invested in an equity mutual fund that is almost 100% risk-free. You will think, have i gone mad?. The answer is NO. Arbitrage Mutual Fund is an equity mutual fund but provides USP of a debt mutual fund i.e. capital safety. Investors invest in Arbitrage Mutual Fund as an alternative to Debt Mutual Fund or during volatile times. Utterly Confused!!!. I also got confused when i first came to know about this product. As i discussed in my post, Debt Mutual Funds – 7 Hidden Risks that contrary to popular perception, debt mutual funds are not safe. I also suggested against equity mutual funds in my post, Negative Mutual Fund Returns. Now my readers will kill me. A million dollar question is where to invest. The answer is during volatile times; Arbitrage Mutual Fund is your best friend. Currently, i have shifted my equity and debt investments to Arbitrage Mutual Fund. Arbitrage Mutual Fund take advantage of Arbitrage opportunities available in the market to generate returns. Before we move ahead, it is important to understand arbitrage opportunity.
What is Arbitrage Opportunity?
I am not the first one to explain this concept, but i will try to explain with a real life example. In layman terms, An arbitrage opportunity is to take advantage of price differential in two different markets. Let me share an example. A friend of mine has created a business by taking advantage of the arbitrage opportunity. She was my batch mate in management school. During those days, she visited Malaysia to celebrate her parents anniversary. She bought a bunch of lily flowers as these flowers are her parents favorite. To her surprise, a bunch of 12 lily flowers cost her Rs 1200 in Indian Rupees i.e. Rs 100 for one flower. The cost was Rs 25 per flower in Mumbai. A business idea clicked her. Now she exports lily flowers to almost all the big hotels and distributors in Southeast Asian countries. The price of lily is volatile and can eat into her margin. Therefore, she buys and sell simultaneously. For example, she buys 50 kg flowers at wholesale price Rs 40 per unit. Simultaneously she sells to her clients @ Rs 50 per unit. Therefore, her net profit is Rs 10 per unit. It is secure transaction as it is simultaneous buy and sell. She hedges her position against any price volatility. Her business model is based on price differential between 2 different markets.
Similarly, Arbitrage Mutual Fund also take advantage of price differential of a security in different markets. These funds book net profit equivalent to the price differential. This difference is normally minuscule therefore large quantities are traded to generate returns. As a retail investor, you must have observed price difference between BSE and NSE price of a stock. Similarly, there is always a price differential between Spot Price and Future price. In short, profit from price differential in different markets is an arbitrage opportunity.
Is Arbitrage Mutual Fund Safe?
The modus operandi of Arbitrage Mutual Fund to generate returns is such that it is nearly 100% safe. Why i mentioned close to 100% safe, in the above example though my friend hedged her positions fraction of risk element cannot be ruled out. The biggest risk is of availability of arbitrage opportunities. These opportunities are aplenty during volatile markets. Therefore, i mentioned Arbitrage Mutual Fund is your best friend only during volatile times. During stable market, no. of arbitrage opportunities are fewer, therefore, lower returns. In my friends case, if the price differential between Indian and South East Markets is bridged then there is NO Arbitrage opportunity. Therefore, she cannot generate any business.
Another risk is of liquidity. To generate a return, the traded volumes are high. Therefore, at the time of unwinding of position, if the position is not squared off due to low volumes then there is a risk of loss.
Lastly, these funds invest 65% of AUM in equity as it is equity mutual fund. The limited no of stocks in derivative segment further limit the arbitrage opportunities in the market.
The element of risk due to factors above-mentioned is just a fraction of the total investment. I studied the short term and long term returns of top 5 Arbitrage Mutual Fund. I could not find negative returns during any particular period. The reason being, as the risk is a fraction of total investment, therefore, it is covered up by other trades. The probability of risky trade is very low.
The best example, i can share on the safety of Arbitrage Mutual Fund is related to their exposure in Amtek Auto. Collectively all the arbitrage funds had exposure of 65 Cr in Amtek Auto. The collapse of its stock price had NO impact on the Arbitrage Mutual Fund. Reason being, the position of Arbitrage Mutual Fund was fully hedged in the derivative market. For more details, you may check the article published in Business Standard.
After reading the post on Business Standard, i concluded that Arbitrage Mutual Fund is 100% SAFE. Please note that it is my opinion.
Stable Returns and Tax Advantage
Besides safety, Arbitrage Mutual Fund provide stable return and tax advantage compared to debt funds & FD’s. Over a period, the returns from Arbitrage Mutual Fund are stable between 7.5% to 10%. Moreover, being an equity mutual fund, long-term capital gain tax is NIL if you hold for more than one year. Short term capital gain tax is 15% i.e. if you sell before one year. For an investor in 30% tax bracket, the pre-tax return can be average 12% if you sell after one year. Also, note that long-term performance of average performing equity mutual fund is also 8% to 9% post tax. Therefore why to lose sleep in equity.
Golden Words: During my analysis i observed that Arbitrage Mutual Fund schemes with less AUM perform better than schemes with high AUM. The reason being, no of arbitrage opportunities in the market are limited. A scheme with less AUM can deploy funds more effectively and efficiently compared to large schemes. Personally, i have invested only in schemes with AUM more than 1000 Cr. Therefore, it is at the discretion of readers whether to invest in small or large schemes. I only shared my observation that i noted while studying the relation between AUM and the returns.
The no. of safe and secure investment opportunities are shrinking. In my opinion, Arbitrage Mutual Fund is one such opportunity. It is best suited during a volatile period. According to experts, the volatility will last for some more time, and i am happy to be in volatile markets.
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