4th August 2021
Finance

Are arbitrage funds a good substitute for debt funds?

If you are someone who has just learnt about mutual fund investments are keen on investing a decent chunk of your savings in these market linked schemes, we recommend you consult a financial advisor before making an investment decision. Mutual fund schemes do hold the potential to offer exceptional capital gains, but it is essential for investors to first understand their appetite for risk before investing. Mutual funds are a pool of professionally managed funds that invest in a diversified portfolio of securities. Depending on the nature of the scheme and its investment objective a mutual fund may invest across various asset classes like equity, debt, corporate bonds, government securities, gold, real estate, company fixed deposits, treasury bills, etc. The performance of a mutual fund scheme depends on the performance of its underlying assets and the various sectors and industries in which it invests. Mutual fund investors are referred to as unit holders and they are allotted units in quantum with the investment amount and depending on the fund’s existing NAV (net asset value).

Market regulator SEBI has further categorized mutual funds based on its several unique attributes like fund size, asset allocation strategy, its underlying index, risk profile etc. Although equity schemes are the most sought after mutual fund products, investors looking for diversification also invest in debt funds. Mutual fund advisors recommend investing in both equity and debt asset class depending on the investor’s risk appetite.

What are arbitrage funds?

An arbitrage fund is an open ended hybrid fund which is expected to follow an arbitrage strategy where the total assets, a minimum of 65 percent investment must be made in equity and equity related instruments. The nature of arbitrage funds is to repress the difference between cash and future markets and then invest in the cash market and sell in the future market. Arbitrage funds mostly function in two markets – (equity) cash and derivatives (futures). The futures market, unlike the equity market, considers a future anticipated price for the valuation of the equity stocks. The existing price of security is termed as the spot price. The futures trading date predetermined in the futures contract is specified as the maturity date.

Is arbitrage fund a better investment option than debt funds?

In order to determine whether an arbitrage fund is a better investment option for you, it is essential for investors to understand how arbitrage funds work.

Let’s take an example to understand better how arbitrage funds work:

If an arbitrage fund purchased 2000 shares from company A at the price of Rs. 10 per share in February and sold these for Rs. 20 at the end of June as per futures contract, there are two considerations:

Situation 1 –
The stock price at the maturity date: Rs. 30
Profit/Loss of the spot transaction in the cash market: (30-10) x 2000 = Rs. 40,000
Profit/Loss of futures transaction in futures market: (20-30) x 2000 = Rs. – 20, 2000
Overall profit made by the arbitrage fund: 40000 – 20000 = Rs. 20,000

Situation 2 –
The stock price at maturity date: Rs. 15
Profit/Loss of the spot transaction in the cash market: (15-20) x 2000 = Rs. – 10,000
Profit/Loss of the spot transaction in the futures market: (30-15) x 2000 = Rs. 30,000
Overall profit made by the arbitrage fund: 30000 – 10000 = Rs. 20,000

Although in the above example, the arbitrage fund manages to make profits irrespective of the market vagaries, this may not be true in real life, and the fund may even suffer losses. Since this hybrid fund is able to take advantage of market fluctuations, they might turn out to be an ideal investment choice as compared to debt funds. However, investors who only understand the functioning of arbitrage funds should consider investing in them.