Arbitrage funds have grown in popularity after the changes to the taxation of debt mutual funds. Bajaj Finserv has recently come out with an NFO too.
Such funds allocate a minimum 65% to equity and equity related instruments through spot-future arbitrage. Hence, the taxation is as per equity funds.
The arbitrage category is typically used by investors to park their short-term money. During volatile markets, such funds have the potential to garner a slightly higher return than the relatable fixed-income categories. Therefore, the quantum of both inflows as well as outflows is generally high during such periods.
The category witnessed net inflows of Rs 9,482.6 crores (August 2023) and Rs 10,074.8 crores (July 2023).
How do they function?
Arbitrage Funds generate returns by exploiting mispriced opportunities between spot and futures prices in cash and derivative markets. Arbitrage opportunities can exist in the same stock between different exchanges or between a security and its futures price.
Suppose stock X is trading at Rs 100 on BSE and Rs 101 on NSE, the fund manager would simultaneously buy it on BSE and sell it on NSE at Rs 101, making a profit of Rs 1. Similarly, the fund manager can buy a stock at a spot price of Rs 1,000 in the cash market and simultaneously sell it at Rs 1,002 in the futures market, locking in a profit of Rs 2 over the duration of the contract.
On the date of expiry, if the price differential between the spot and futures position of the subsequent month's maturity still exists, fund managers roll over the futures position and hold onto the position in the spot market.
By buying in the cash market and selling in the Futures and Options market, fund managers lock in profits irrespective of the price movement of the security.
In some instances, fund managers may unwind both the spot and the future position before the expiry of the current-month future for generating higher returns or to meet redemptions.
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