Securities like stocks are listed across multiple exchanges. Often there is a difference in the price of the security across markets. Arbitrage mutual funds try to take advantage of this difference in pricing. Read this post to understand what these funds are and how they work.
If you have ever invested in the Indian stock market, you may know that there are two major exchanges in India- NSE and BSE. Most popular stocks are listed on both these exchanges. Similarly, within exchanges like Nifty, a particular stock can be purchased/sold at its spot price, or the same can be done with the help of the derivatives market.
Often there is a small difference in the pricing of stocks between exchanges and between the spot price and future price of the stock.Arbitrage funds exploit this difference in pricing to generate returns for investors. Take a look at what these funds are and how they work.
To understand arbitrage funds, you should first understand the meaning of the arbitrage trading strategy. Arbitrage trading is when an investor purchases and sells or sells and purchases security simultaneously and earns profit from the difference in pricing.
In simple words, particular security is purchased from one market and simultaneously sold in another market. Similarly, it can also be sold in one market first and then purchased in another market. The difference in pricing is the profit of the investor.
Arbitrage mutual funds in India try to take advantage of this difference in the pricing of instruments between markets. An example would be purchasing 1000 qty of ABC stock at Rs. 100/share on BSE and selling the same on NSE at Rs. 102/share. This transaction would result in a profit of Rs. 2/share.
This can also be done between the spot market and the futures market. Moreover, apart from stocks, this can also be done for commodities and currencies across different markets.
If you wish to purchase 1,000 shares of a particular company, the spot price of the stock is Rs. 100 a piece in the cash market. So, for buying 1,000 shares, you must spend Rs. 1 lakh. Now, there is a different futures market in the derivatives segment. In the futures market, stocks are priced based on their anticipated price in the future and not their spot price.
For instance, it is possible for the same Rs. 100 stock to be trading at Rs. 102 in the futures market. In the futures market, trading occurs on a contract-basis where every stock is traded in lots of various quantities. Also, the contracts have a fixed monthly expiry.
Now that you know what arbitrage funds are and the difference between cash and futures market, it should be easier for you to understand how an equity arbitrage fund works. While there are many different ways to do arbitrage trading, arbitrage funds generally follow these two strategies
So, let us assume that the fund manager of a particular arbitrage fund believes that the price of a stock is about to rise soon. The spot price of the stock in the cash market is Rs. 100, and the same in the futures market is Rs. 102.
So, the fund manager can purchase the share at the spot price of Rs. 100 from the cash market. Simultaneously, he will short a futures contract of the same stock at Rs. 102. Now, around the futures contract expiry when the spot price and the futures price of the stock coincide, shares purchased from the cash market will be sold in the futures market.
By doing this, the fund manager will earn a profit of Rs. 2/share. The same process can also be done when the fund manager believes that a particular stock is about to fall. But when the stance is bearish, fund managers first purchase long contracts in the futures market and short-sell the shares in the cash market.
As compared to arbitrage trading between the cash market and futures market, arbitrage trading between exchanges is easier to understand. As mentioned in the beginning, arbitrage trading between exchanges is purchasing shares from one exchange and then selling the same on the other exchange. Similarly, the shares can be first sold in one exchange, and then bought on the other exchange. This can be done between NSE and BSE.
So, the arbitrage fund manager could purchase a particular stock at Rs. 100 from NSE and then sell the same on BSE for Rs. 100.20, resulting in a profit of Rs. 0.20/share.
No, arbitrage funds also generally have decent exposure to fixed-income instruments. This helps in balancing the volatility of arbitrage trading. Quality debt instruments like debentures, term deposits, zero-coupon bonds are preferred by fund managers to ensure that the arbitrage fund can deliver returns even if there are not a lot of arbitrage trading opportunities
While arbitrage fund meaning can be a little difficult to understand, especially if you are new to the equity markets, it is a low-risk trading strategy. So, these funds are ideal for risk-averse investors.
A lot of equity mutual fund investors also switch to arbitrage funds when the market is volatile. Also, unlike mid-cap and small-cap equity funds that are ideal for investment horizons of 3-5 years and more, arbitrage funds can be considered for short to medium duration.