What is Arbitrage Trading? What are Arbitrage Funds?

Stock markets are often unpredictable due to volatility. When stock markets become volatile, investors flock to debt investments. However, debt securities have also been experiencing the effects of the RBI’s rate cuts. Also, debt investing does not offer the same tax efficiency as stocks. When equities are volatile, and debt securities offer low returns, what should investors choose? Arbitrage Funds would be the apt choice. These funds help you make smart investment choices that can help you turn a profit quickly. Volatility and arbitrage funds are a good fit, as they generally provide better post-tax returns than liquid funds. An arbitrage fund is a type of investment fund that specializes in making quick profits by exploiting price discrepancies between two or more markets.

Arbitrage Funds

Arbitrage is the simultaneous buying and selling of assets in two different markets (that is, the cash market and the futures market) to profit from the price inefficiencies across these markets. Arbitrage funds use a principle called arbitrage to make profits. This principle is simple to understand once you understand the cash market and futures market.

Let’s first understand the two markets that we are referring to.

Cash Market

The cash market is the market where transactions are settled on the spot. For example, consider the secondary equity markets. When you buy shares on the NSE, your account is debited with the funds, and your transaction is settled immediately.

Futures Market

A futures market is a market where you can buy the right to buy or sell an asset at a predetermined price on a future date. An arbitrage trade is designed to take advantage of the price difference between the spot and futures markets for an asset.

What is Arbitrage Fund Taxation?

Since arbitrage funds are classified as equity funds, they are taxed in the same way as other equity funds. This allows arbitrage funds to avoid paying taxes on their LTCG (long-term capital gains) income. If you hold the investments for more than one year, the returns are considered LTCG and are tax-free. However, if you withdraw the investment a year ago, the returns are considered STCG (Short Term Capital Gains) and are taxed at 15%.

Arbitration schemes need to make many trades each year to make a significant profit. To get the best returns from your investments, you need to keep them in these funds for at least three months. This helps to smooth out day-to-day fluctuations and gives you reliable arbitrage fund returns.

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Arbitrage Mutual Funds

Many investment experts believe that taking advantage of arbitrage opportunities is the best way to make money. Arbitrage is finding and capitalizing on price differences in the same security between two or more markets. As an investor, if you find that the price of a stock will be different in the future and the cash markets, you have the opportunity to capitalize on it. However, this requires a lot of research and understanding of how the market functions. Not all investors have the time or knowledge to do extensive research. Arbitrage mutual funds provide investors with opportunities to profit from price differences between two markets.

This is a fundamentally different way of investing where you purchase an asset and hold on to it, rather than selling it and waiting for it to grow in value. An arbitrage fund manager only invests in equities when he finds an opportunity to earn a positive return. If there are no arbitrage opportunities available, the fund invests in short-term money market instruments and debt securities. It is important to note here that the price difference is usually very small. The fund manager has to make several trades to make a reasonable profit.

Arbitrage funds are similar to debt funds in that their risk profile is relatively low. There are various arbitrage funds using the liquid fund index as their benchmark. Arbitrage funds are ideal for investors who want to invest in stocks but don’t want to take any risks. In a volatile market, many risk-averse investors can park their money in an arbitrage fund and get good returns.

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