Arbitrage funds have gained significant popularity in India, especially during volatile market periods. These funds aim to deliver consistent returns with lower risk compared to pure equity funds. But how exactly do they achieve this? Let’s get into the world of arbitrage funds and understand their working, risks, returns, and suitability for Indian investors.
What are Arbitrage Funds?
Arbitrage, at its core, is the practice of capitalizing on price differences of the same asset in different markets. Arbitrage funds apply this principle to the stock market. They simultaneously buy and sell the same security in different segments – typically the cash market (where stocks are traded directly) and the futures market (where contracts for future delivery of stocks are traded). This strategy allows them to lock in a profit, irrespective of the market direction, making them relatively less volatile.
Arbitrage funds typically invest at least 65% of their portfolio in equities and related instruments. The remaining portion of the portfolio is often held in high-quality debt and cash instruments. This structure not only facilitates the arbitrage strategy but also manages margin requirements and liquidity needs for potential redemption demands.
How do Arbitrage Funds Work?
The key principle driving arbitrage funds is the “cash and carry arbitrage” strategy. Let’s understand this with a simplified example:
Scenario:
- Reliance Industries is trading at ₹3,000 in the cash market.
- The futures contract for Reliance Industries expiring in a month is trading at ₹3,040 in the futures market.
Arbitrage Opportunity:
- The fund manager buys Reliance Industries shares in the cash market for ₹3,000.
- Simultaneously, they sell a futures contract for Reliance Industries at ₹3,040.
- On the expiry date of the futures contract, the price of the stock in both markets theoretically converges.
Possible Outcomes:
- Scenario 1: The Reliance Industries stock price rises to ₹3,100 on expiry.
- The fund manager sells the shares in the cash market for ₹3,100, gaining ₹100.
- They buy back the futures contract at ₹3,100, losing ₹60.
- Net Profit: ₹40
- Scenario 2: The Reliance Industries stock price falls to ₹2,900 on expiry.
- The fund manager sells the shares in the cash market for ₹2,900, losing ₹100.
- They buy back the futures contract at ₹2,900, gaining ₹140.
- Net Profit: ₹40
- Scenario 3: The Reliance Industries stock price remains at ₹3,000 on expiry.
- The fund manager sells the shares in the cash market for ₹3,000, neither gaining nor losing.
- They buy back the futures contract at ₹3,000, making a profit of ₹40 (the difference between the initial buy and sell prices).
- Net Profit: ₹40
As you can see, regardless of the price movement, the arbitrage strategy ensures a profit due to the initial price difference between the two markets. This is a simplified illustration, and actual scenarios might involve transaction costs and other factors.
Exchange Arbitrage
Exchange arbitrage refers to the practice of exploiting price discrepancies between different markets for the same asset to make a profit. In the context of the Indian stock market, arbitrage can be conducted between the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), which are two of the primary stock exchanges in India.
Here’s a simple example to explain how arbitrage works between NSE and BSE:
- Identify a Price Discrepancy: Assume that the stock of Company XYZ is trading at ₹100 on the NSE and ₹102 on the BSE.
- Simultaneous Buying and Selling: An arbitrageur would buy shares of XYZ at ₹100 each on the NSE and simultaneously sell the same number of shares at ₹102 each on the BSE.
- Profit from the Differential: The difference in prices (₹102 – ₹100 = ₹2 per share) represents the arbitrageur’s profit, excluding transaction costs such as brokerage fees, taxes, and other charges.
- Settlement and Risk: The trades are settled at the end of the trading day, and the arbitrageur benefits from the price differential assuming no change in the prices after executing the trades. However, this strategy is not without risk; price movements in the short window between trades can erase profits or even lead to losses.
Arbitrage opportunities are typically short-lived as the act of arbitraging contributes to correcting the price discrepancy between the markets. With advanced trading systems and algorithms, these opportunities can be identified and acted upon within seconds, making it a competitive and technology-driven strategy primarily used by institutional investors and professional traders.
Index Arbitrage
At its core, index arbitrage involves comparing the futures price of a stock index with the actual prices of the stocks in the index traded in the spot market. The aim is to find and exploit any discrepancies between these two values. The principle is straightforward: if the index’s futures are overpriced compared to the aggregate spot prices of its constituent stocks, an investor can make a profit by taking counter-positions in both markets.
A Practical Example
Let’s consider a hypothetical situation with the Nifty 50 index to illustrate how index arbitrage works:
- Assume the Nifty 50 index is trading at a higher price in the futures market than the combined spot prices of its constituent stocks.
- An arbitrageur would buy the individual stocks at the lower spot prices while simultaneously selling the Nifty 50 index futures at the higher futures price.
- The strategy here is to wait until the futures contract nears its expiry, at which point the prices in the futures market are expected to align with the spot market prices. The initial difference between the two prices (the spread) represents the arbitrageur’s profit.
Execution and Risks
Implementing index arbitrage requires precision and speed. Discrepancies between the futures and spot prices are typically fleeting, often corrected by the market within moments. To capitalize on these opportunities, arbitrageurs rely on advanced algorithms and automated trading systems that can execute trades instantly when conditions are favorable.
While potentially profitable, index arbitrage is not devoid of risks. Execution risk, the possibility of trades not being executed at anticipated prices, and model risk, where the arbitrage model may be flawed, are significant considerations. Furthermore, the opportunities for arbitrage might be confined to periods of heightened market volatility or pronounced price discrepancies.
Arbitrage Funds with Highest AUM (Data as on 27th Apr 2024)
Characteristics of Arbitrage Funds:
- Simultaneous Buy and Sell Transactions: They involve buying and selling the same security at the same time.
- Same Security Transacted: They deal with the same underlying asset in different markets.
- Different Markets: The transactions occur in separate market segments, such as cash and futures.
Risks and Returns:
- Lower Risk: Arbitrage funds are considered less risky than pure equity funds as their returns are not directly linked to market movements.
- Moderate Returns: They generally deliver returns comparable to liquid funds or short-term debt funds, ranging between 6-8% per annum.
- Execution Risk: The success of arbitrage depends on the fund manager’s ability to identify and execute opportunities efficiently.
- Volatility Risk: While less volatile than equities, returns can fluctuate due to changing market conditions and narrowing spreads.
The Right Time to Invest in Arbitrage Funds:
- High Volatility Periods: When markets are volatile, arbitrage opportunities tend to increase, making it a favorable time to invest in these funds.
- Rising Interest Rate Scenarios: As interest rates go up, the spread between cash and futures prices widens, potentially leading to higher returns.
Portfolio Composition
To manage liquidity and risk, arbitrage funds often diversify their portfolio with:
- Arbitrage Positions: The core of the portfolio, aiming to capture price differentials.
- Equity and Related Instruments: A smaller portion invested in stocks for potential capital appreciation.
- Debt and Term Deposits: Investments in fixed-income securities for stability and income generation.
- Liquid Funds and Cash: To ensure sufficient liquidity for redemptions and capturing arbitrage opportunities.
Taxation
Arbitrage funds are taxed like equity funds. Short-term capital gains (holding period less than 12 months) are taxed at 15%, while long-term capital gains (holding period greater than 12 months) exceeding ₹1 lakh are taxed at 10%.
Should you Invest in Arbitrage Funds?
Arbitrage funds can be a suitable investment option for investors seeking:
- Low-risk investments with moderate returns: Ideal for risk-averse investors or those looking for a temporary parking space for their funds.
- Tax-efficient returns: Benefit from equity taxation, which can be advantageous compared to debt funds for shorter holding periods.
- Diversification: Add a layer of stability and reduce overall portfolio volatility.
