Arbitrage Anyone?

This is a turbulent market which is confusing for the best of us. Interest rates are falling, stock prices are rising for no clear reason and many feel the best way forward is to tuck their money under the mattress. 

In the old days, stock brokers used a product called "vyaj badla" to make fabulous double digit returns. Today, those returns are not so fabulous, but the product is still available, albeit in a slightly new avataar - arbitrage funds. 

Arbitrage funds are an good way of earning a reasonable income from equities with  a very modest amount of risk, And here's how. These funds basically generate income by taking advantage of the spread opportunities arising out of the mis-pricing between two markets-Cash and futures

Let's illustrate this concept with a hypothetical situation: 

Take Company XYZ :

Spot Market rate    =  Rs. 500

Futures Rate          = Rs. 510

Spread                   = Rs.  10

So what does the Fund Manager do? He buys in the spot market and simultaneously sells the same share in the futures market.  In this way, he earns a risk-free profit of Rs. 10 per share (minus relevant transaction costs). The best part about such profit earnings is that they can come irrespective of the overall market movement. . An arbitrage fund carries out a number of such transactions to generate favourable returns.

Sounds highly appealing, doesn't it? There’s more:

•  The profits of an arbitrage fund become tax-free after a year as they are equity funds.
•  Dividends in these funds are tax free too.
•  Since the fund manager buys in cash, he gets to keep the shares as security till the trade is closed.

         

So what’s the downside?

•  A large asset size. If the assets managed by an arbitrage fund increases heavily, then a majority of the assets would remain parked in money market instruments simply because of the lack of enough arbitrage opportunities.
•  Arbitrage funds generally thrive on volatility. The higher the volatility in the markets, the higher is the potential of mis-pricing between the spot and derivatives markets. Hence, at times like these, when the markets are at their volatile best, arbitrage funds might just turn out to be a  form of investment.

A word to the wise. Please chose the right kind of arbitrage fund. As always, there are several offerings and not all maybe what you should put your money into. Again, mutual funds are subject to market risks.