Are you looking for a tax-efficient investment? Do you want to invest in an equity-oriented instrument? You may consider putting your money in an arbitrage fund. It invests at least 65% of the total assets in equity-related instruments. An arbitrage fund follows a strategy of simultaneously buying and selling securities in different markets. It makes money by exploiting the difference in price between the cash and the futures market.
Here’s everything you should know to decide if you should invest your money in an arbitrage fund.
How do arbitrage funds work?
The term ‘arbitrage’ means the same security is bought and sold in two different markets to gain from the price difference. You may purchase a share in the cash market; for example, the stock exchange, such as the NSE or the BSE is a cash market. You receive the shares you buy immediately in exchange for cash. The price of the security on the stock exchange is called the spot price.
You may purchase a share in the futures market that considers the anticipated price of a security at a future date. You will find the future date of the transaction or the maturity date mentioned in the futures contract. You get the share that you purchase from the futures market on the maturity date of the agreement. The pre-determined price of the share is called the futures price.
The fund manager evaluates the difference in the price of the shares between the cash market and the futures market. For example, if the cost of the shares in the futures market is above the cash market, the fund manager purchases the shares in the cash market.
The fund manager would sell an identical quantity of the shares at the same time in the futures market. The fund manager makes a profit based on the difference in price between the two markets. However, the fund manager has to hold the position until the expiry date of the contract to earn a profit.
Should you put money in arbitrage funds?
You may invest your money in an arbitrage fund for a time horizon of one to three years. Invest in an arbitrage fund only if you are comfortable with holding an investment in stocks. You may consider investing in arbitrage funds, depending on your risk profile.
The arbitrage fund is a low-risk investment as compared to many equity funds. However, you may lose money if there is a deep correction in the stock market. The arbitrage fund also invests your money in fixed income securities.
You must check the credit quality of the debt portion of the portfolio to reduce the credit risk. It is the chance that the borrower may default, on either the principal or the interest payment, on the fixed income instrument.
Arbitrage funds invest a lump sum in equity-related instruments. The taxation of your short-term and long-term capital gains are just like equity funds. You may consider putting your money in arbitrage funds if you fall into the higher tax brackets.
You must take a look at your investment goals and tax liability before investing your money in the arbitrage fund. Check the size of the total assets under management of the fund house before putting your money. You must take a look at the track record of the fund house over some time. Select an arbitrage fund with a low expense ratio to ensure a higher return. Make sure your arbitrage fund is true to label. It must generate a return from arbitrage and not from fixed income. In a nutshell, an arbitrage fund is good if it matches your financial goals and risk tolerance.
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