How safe are arbitrage funds? Should they form a part of an investor's portfolio?
These are funds which try to capture the benefit from the mispricing opportunities between the cash and futures market in the equity segment. That is how they earn returns. Now let me try and give you an over-simplistic example to explain this. Let's say, there is a stock which trades at Rs 100 in the cash market and at Rs 101 in the future market. So, by spotting this price differential, an arbitrage fund buys the stock in the cash market at Rs 100 and sells it in the futures market at 101. Thereby locking this Re 1 differential through these trades.
Now, on the settlement date in the futures market, which happens towards the end of the month, the prices in stock and futures market would converge and that is when the fund can simply reverse these transactions so it can sell this stock in the cash market and buy it in the futures market, thereby undoing the trades it did initially. Once it does that, it is sure to get this Re 1 differential, irrespective of where the price of this is on the settlement date, i.e., irrespective of whether the stock price has crashed to Rs 50 on the settlement date, or it has gone up to Rs 150. The fund is sure to pocket this Re 1 gain. So, this is what an arbitrage fund looks to do to earn the return. Until it doesn't find enough mispricing opportunities to execute such trades, it keeps the money invested in liquid fund type securities like treasury bills or very short-term fixed deposits.
Now, from a risk perspective, they are fairly low on risk. While they might turn out to be volatile over very short periods, for an investment horizon of upwards of 3-month period, the chances of earning negative returns are fairly low. But also note that you can't expect very high returns from them. You can only expect returns like that of a liquid fund, which means, returns that are only slightly better than a bank account.
That's why these funds are not suitable if your goal is to generate wealth in the long run. Additionally, they have relevance for investors who are looking to park their money for a few months to upto a year. Even there, these funds are more beneficial for those in the higher tax bracket of 30 per cent because unlike liquid funds, these funds are able to fetch the preferential tax treatment of an equity fund which tends to lower the tax liability for investors who are in the higher tax bracket. So, for that kind of investors, they might have limited appeal. But for others looking to invest for very short periods, liquid funds can just be good enough.