Understanding arbitrage funds: A smart investment strategy for volatile markets

Worried which way the markets will head if the conflict in Israel escalates into a full blown war? There is a way to profit from the wild swings in the market. Yes, when markets are choppy there is a way to profit from them by benefiting from the price difference in the cash and the futures market. Gaining popularity are arbitrage funds that come with very low risk. These funds tend to take advantage of price discrepancies between the cash and futures markets, offering investors an opportunity to generate profits even in turbulent times.

Business Insider delves deep into this product to explain the concept, benefits of investing in such funds, and the potential drawbacks investors should consider.

What is arbitrage?

Arbitrage involves buying and selling an asset simultaneously in two different markets to profit from price inefficiencies. In the case of arbitrage funds, these transactions occur between the cash market and the futures market. The cash market refers to the spot market where transactions are settled immediately, while the futures market allows investors to buy or sell an asset at a predetermined price on a future date.

How do arbitrage funds work?

Arbitrage funds are mutual funds that aim to generate profits by exploiting price differentials between the derivatives and cash markets. For example, an arbitrage fund may buy an asset in the cash market and simultaneously sell it in the futures market at a higher price, locking in an immediate gain. These funds thrive on market volatility, as it creates more opportunities for price discrepancies.

Advantages of investing in arbitrage funds:

1. Minimal Risk: Arbitrage funds are considered low-risk investments, making them an ideal choice for investors seeking decent returns with minimal risk. They are often compared to pure debt funds in terms of risk levels.
2. Ideal for Volatile Markets: Unlike most funds that may experience negative returns or high unpredictability during market volatility, arbitrage funds thrive in unstable market conditions. The returns and volatility go hand in hand.
3. Tax Benefits: Arbitrage funds are treated as equity funds for tax purposes. This means that if you hold the funds for more than a year, they will be taxed as long-term capital gains, resulting in potential tax savings.

Drawbacks of arbitrage funds

1. Mediocre Reliability: Arbitrage funds may not be very profitable during stable market conditions. If there are not enough profitable arbitrage trades available, the fund may temporarily perform like a bond fund, affecting its profitability.
2. Unpredictability in Payoffs: The profitability of arbitrage funds is dependent on the availability of profitable arbitrage trades. During stable markets, when such trades are scarce, the fund's performance may suffer.
3. High Investment Costs: Arbitrage investments come with various costs, including expense ratios, turnover ratios, and transaction costs. Additionally, exit loads may be imposed to discourage premature exits, further reducing take-home returns.

Arbitrage funds offer investors a unique opportunity to generate stable returns in volatile markets by capitalising on price discrepancies between the cash and futures markets. While these funds provide minimal risk and tax benefits, investors should be aware of their mediocre reliability during stable market conditions and the associated investment costs. It is crucial to carefully consider these factors and consult with a financial advisor before investing in arbitrage funds to ensure they align with your investment goals and risk tolerance.