Arbitrage funds are suited for investors with a low risk appetite who wish to take equity exposure for a short period of time.
Arbitrage funds take advantage of the differences in prices of shares in cash and derivatives market by investing simultaneously in same stock. They work best in volatile markets as the fund takes opposite position in cash and futures market to make profits.
These funds look for events such as share buy backs by companies and dividend declaration for generating arbitrage opportunities.
Example
Suppose a fund manager buys 100 stocks of a company on January 10, which is trading at Rs 50 in the cash market, the investment value works out to Rs 5000. On the same day, the fund manager sells 100 stocks in the futures market at Rs 53 per share which works out to Rs 5300.
The fund manager sells the stock in cash market on February 10 at Rs 60, making a profit of Rs 1000 and buys futures at Rs 55, making a loss of Rs 200.
The fund manager made a profit of Rs 1000 in the cash market and makes a loss of Rs 200 in the futures market. The scheme makes a net profit of Rs 800. Suppose the fund had a corpus of Rs 1 lakh and after adding the profits the corpus now stands at Rs 1, 00,800. This means the fund has generated 1% return.
The funds are suited for investors wanting to earn slightly higher returns than debt funds over a short period of time.
These funds are treated as equity oriented funds since they invest a minimum of 65% of the corpus in equities. Arbitrage funds deploy surplus cash in fixed income markets. Most of these funds are benchmarked against Crisil Liquid Index. These funds deploy their money in short term debt or money market securities when the fund manager does not find any arbitrage opportunities.
Presently there are 14 arbitrage funds in the market. These funds generated 9% return over a one year period (slightly better than gilt and liquid funds) and 7% over a three year period. (Source: Valueresearch) A CRISIL report released in July showed that arbitrage funds had generated 9% post tax returns during 01 July, 2011 to 30 June, 2012, compared to 8.4% by debt funds and - 4.1% by equity funds. The report showed that during the volatile stock market period of 2006-2008, arbitrage funds delivered post-tax returns of 8-9%.
As the dividend declared by arbitrage funds, which are treated on par with equity funds are tax free, these funds become more lucrative than short-term debt funds which pay a dividend declaration tax of 13.5%.