Arbitrage Funds – How Arbitrage Mutual Funds Profit from Price Differences in the Market

Arbitrage Funds

Do you remember the above game? Finding differences between two seemingly identical pictures? The differences were tiny but our happiness on discovering them was unparalleled.

Let us revisit this game. Can you spot the difference between the below images?

Image 1:

Arbitrage Funds

Image 2:

Arbitrage Funds

Both the snapshots show the share price of Reliance Industries. Ideally you would expect them to have the same price on both NSE and BSE. After all, a packet of Maggie costs the same in Mumbai or Punjab!

But when it comes to shares, that’s not the case. The share price of Reliance Industries is Rs 2,086.20 on BSE. Whereas it is Rs 2083.65 on NSE. There is a difference of Rs 2.55 per share.

This difference presents a guaranteed money-making opportunity.

What opportunity? Let me explain.

  • You can buy 100 shares of Reliance Industries on NSE. Your total cost price will be Rs 2,08,365.
  • Almost immediately, you sell these 100 shares on BSE at Rs 2086.20 per share. Your sale price is Rs 2,08,620.
  • You made a risk-free profit of Rs 255 in a matter of seconds!

This is known as ‘arbitrage opportunity’.

What is Arbitrage?

Arbitrage is the simultaneous buying and selling of the same asset in different markets in order to profit from tiny price differences.

In the above definition, note that the asset remains the same. Only the market changes. In our example, the asset was the same i.e. shares of Reliance Industries. We only changed the market from NSE to BSE. At any given point of time, there are multiple arbitrage opportunities in the market. Let us look at the below table.

Arbitrage Funds

Before you start searching for such stocks, here are some things you need to know about arbitrage opportunities:

  • Arbitrage opportunities vanishes in seconds. So you need to make quick decisions.
  • Not all stocks provide arbitrage opportunities. In the above example, there is no arbitrage opportunity in TATA Motors Ltd. Hence, it is important to select stocks which have substantial price difference.
  • Arbitrage opportunities come with minimal price differences. Hence to make higher profits you will have to buy more shares.
  • You should only arbitrage in stocks with high volumes otherwise you’ll be stuck with no exit route.

More Shares = More Profits from Arbitrage Opportunities

Share Share Price
on NSE
Share Price
on BSE
Difference between
share prices
Profit on
10 shares
Profit on
100 shares
Profit on
1,000 shares
Infosys Ltd 1,377 1,382 5 46 460 4,600
TCS Ltd 3,162 3,161 2 18 180 1,800
HDFC Bank Ltd 1,498 1,497 1 8 75 750
Bajaj Finserv Ltd 9,434 9,454 20 202 2,020 20,200
TATA Steel Ltd 741 741 1 5 50 500
TATA Motors Ltd 310 309 0 1 10 100

Yes, there is a special category of mutual funds known as arbitrage mutual funds. In an arbitrage fund, the fund manager pools money from various investors. This pooled money is used to simultaneously buy and sell shares.As you can see, profits start to increase as you start increasing the number of shares. But not all investors can buy stocks worth lakhs and crores! So, how can you take advantage of these arbitrage opportunities with a small investment amount? Two words – Arbitrage Funds.

Arbitrage funds do not buy and sell in the cash markets only. In arbitrage funds, the simultaneous buying and selling takes place in cash and futures market.

What are Arbitrage Funds? – Definition of Arbitrage Funds

Arbitrage fund is a type of hybrid mutual fund. It invests in both equity and debt instruments. The Securities and Exchange Board of India (SEBI) defines arbitrage funds as open-ended mutual fund scheme with minimum 65% of assets in equity and equity related instruments.

But what does ‘Equity & Equity related instruments’ mean?

Equity refers to stocks. Equity related instruments is futures and options (F&O). Unlike other mutual funds, your arbitrage fund also participates in the F&O segment.

We all know that the price of a futures contract is derived from the price of the underlying asset in the spot market. Normally, futures price is higher than spot price. Read our detailed article on futures contract here. Both spot price and futures price are different but converge on expiry.

Share Spot Price (NSE) Futures Price (NSE) Difference between spot & futures price Profit in Futures Market Per Lot
Infosys Ltd 1,369 1,371 1 840
TCS Ltd 3,139 3,141 2 690
HDFC Bank Ltd 1,498 1,502 4 2,172
Bajaj Finserv Ltd 9,395 9,417 23 2,837
TATA Steel Ltd 740 741 1 1,700
TATA Motors Ltd 307 308 1 4,275

Buying 1 share of Bajaj Finserv and making Rs 202? Or,Now what would you prefer?

  • Buying 1 lot of Bajaj Finserv futures and making Rs 2,837!

By switching to a futures contract, you immediately made 1,305% higher profits! Risk-free profit. But not all investors have the ability to pay Rs 90,000 as margin to buy 1 Bajaj Finserv futures contract.

This is why arbitrage funds are perfect for investors who wish to earn high profits from arbitrage opportunities with a small investment corpus.

How Does Arbitrage Funds Work? – Working of Arbitrage Mutual Funds

An arbitrage fund works in two phases –

  • Purchase or sale in cash market
  • Long or short in futures market

The fund manager of an arbitrage fund buys stocks in cash market and sells a futures contract simultaneously. Let us understand this in detail.

  • How an arbitrage fund works when the fund manager expects share price to increase.

Suppose the share price of ABC Ltd is Rs 100 in cash market. The fund manager expects the price to increase to Rs 105. He shorts ABC Ltd futures contract at Rs 102. On expiry, ABC Ltd trades at Rs 105 in both cash and the futures market. At this point your fund manager will square off the position.

Cash Market Position

Purchase Price = Rs 100

Sale Price = Rs 105

Gains = Rs 105 – Rs 100 = Rs 5

Futures Market Position

Sell Price = Rs 102

Purchase Price = Rs 105

Loss = Rs 102-105 = Rs 3

Overall Profit = Cash market profit – futures market loss

= Rs 5 – Rs 3

= Rs 2 – This is your risk free profit! 

  • How an arbitrage fund works when the fund manager expects share price to fall.

If the fund manager expects the share prices to fall in the future, then he will short sell in the cash market at Rs 105. Simultaneously he will go long (buy) in futures market at Rs 102. On expiry, he will square off his position, making a risk-free profit of Rs 3!

This is how an arbitrage fund works to take advantage of the price difference between cash and futures market. Whether your fund buys, sells or goes long or short will depend upon the fund manager.

Fund Manager – Captain of Arbitrage Funds

While all fund managers are equally important, fund manager of an arbitrage fund plays a critical role in the fund’s success. He is responsible for discovering arbitrage opportunities and then quickly taking positions in cash and futures market. Additionally arbitrage fund manager also has to ensure to invest in high quality debt instruments to balance risk from F&O segment.

Should you Invest in Arbitrage Funds? – Advantages of Arbitrage Funds

1. Almost Zero risk: Arbitrage funds engage in buying and selling of the same asset simultaneously. So, they have no long-term risks. Arbitrage funds do not care about long-term prospects of the stock. They only exploit the price difference between the markets to make risk-free short term profits.

2. Balanced Portfolio: Arbitrage funds are balanced funds. They invest 30-35% of their corpus in debt instruments. They invest in zero coupon bonds, treasury bills, AAA rated bonds etc. These instruments carry zero risk. Hence arbitrage funds are able to balance equity risk using debt instruments.

3. Equity Taxation: Arbitrage funds are considered as an alternative to liquid funds. Since they also carry zero risk. But liquid mutual funds follow debt taxation. So you must hold your liquid fund for 3 years to qualify for long term capital gains tax (LTCG). This is not the case with arbitrage funds. You qualify for LTCG taxation if you hold the fund for more than 12 months.

Disadvantages of Arbitrage Funds

1. Average Performance during stable market: Arbitrage opportunities are created during volatile markets. During stable markets, arbitrage funds tend to perform poorly. In such cases, the fund may increase its allocation to bonds, which reduces the overall portfolio returns.

2. Mediocre Returns in ‘Liquid’ fund category: Arbitrage funds are considered to be an alternative to liquid and ultra-short term funds. However their long term performance is worse in comparison.

Arbitrage Funds

3. High Churning Ratio & Expense Ratio: An arbitrage fund is continuously buying and selling stocks. Hence they have a high churn ratio. A high churning ratio directly increases the expense ratio. For example:

A high expense ratio eats into your funds returns. In comparison, liquid funds have an expense ratio between 0.25% – 0.50%.

How are Arbitrage Funds Taxed?

Arbitrage Funds have a holding period of 12 months.

  • If you redeem from arbitrage funds before 12 months, a short term capital gains tax of 15% is applicable.
  • If you redeem from arbitrage funds after 12 months, you pay long term capital gains tax at 10% only if your gains exceed Rs 1 Lakh.

Should You Invest in Arbitrage Funds?

Arbitrage Funds are suitable for investors who want equity exposure without taking risk. But the returns generated by these funds are mediocre. Even among liquid fund category, the 10-year returns are between 4%-5% only. Post tax, these returns are worse than bank deposits. Hence, instead of investing in arbitrage funds, you should invest in liquid funds, ultra-short term funds or money market funds. They generate superior returns plus provide indexation benefit.

Ditch arbitrage funds and invest in liquid funds for superior returns. Invest in best liquid mutual funds in India opening a FREE RankMF account today! RankMF is India’s best mutual fund investment and research platform. Find out the best mutual funds for 2021 for FREE by investing with RankMF.

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