This guide breaks down how arbitrage funds operate, the risks involved, and where returns come from for investors.

This article is a Guest Post from one of Arthgyaan’s earliest readers who is a fellow personal finance enthusiast.

About the author: Muthu Kannan, also known as Manki, is a software engineer by profession. He is intrigued by all sorts of things in life. One of them happens to be personal finance and investing.

In the personal finance space, his passions include teaching others (which is just a fancy name for learning by answering other people’s questions), building tools (mostly spreadsheets as of now), and writing about his revelations occasionally.

Readers of Arthgyaan may be interested in his blog posts about personal finance. Links to his other work and social media handles are on his home page manki.in.

Now over to Muthu Kannan (aka Manki).

📚 Table of Contents

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• How Do Arbitrage Funds Make Money?
  • Arbitrage in a generally positive market
  • Arbitrage in a generally negative market
• What Are the Risks of Arbitrage Funds?
• Alternatives to arbitrage funds

How Do Arbitrage Funds Make Money?

Arbitrage funds earn profits by exploiting price differences between cash and futures markets. In a rising market, they buy stocks and sell futures at a premium, locking in risk-free gains. In a falling market, they short-sell stocks and buy futures at a discount. These strategies ensure returns regardless of price fluctuations, making arbitrage funds attractive for low-risk investors.

Arbitrage funds have become popular in recent years. Not because of their own merit, but because shorter duration debt funds-which can be considered alternatives for arbitrage funds-have gotten worse. Gains from debt mutual funds are now considered short-term irrespective of the holding period while arbitrage funds retain their attractive equity taxation. Many investors are choosing arbitrage funds for short-term cash holding, and possibly even for long-term debt allocation.

It remained unclear to me how arbitrage funds make money despite seeing many explanations. I have the privilege of randomly messaging Sayan, and he’s always been generous. I asked him my questions about arbitrage funds, and learnt how they worked. This post is my understanding of arbitrage funds, most of which I learnt from Sayan. It goes more than skin-deep to provide a (hopefully) clear picture of how these funds make money.

How Do Arbitrage Funds Make Money?

Arbitrage in a generally positive market

Let’s say the market is generally positive. The market expects the price of many shares to go up in the short-term. In such a scenario, futures of shares would be trading at a premium. An arbitrage fund can buy 10,000 shares of a company at ₹1,000 and simultaneously sell 10,000 futures of the same shares at ₹1,010 per future. On the settlement day, the fund will deliver the 10,000 shares it has bought. Irrespective of whether the share price rises or falls, the fund makes a gain of ₹10 per share. Whatever is remaining of the ₹10 after paying transaction costs goes to the investors.

Arbitrage in a generally negative market

If the market mood is negative, futures for shares trade at a discount. In such a case, an arbitrage fund does what’s called “reverse cash and carry arbitrage” to make money.

Let’s say a company’s shares are trading at ₹1,000 in the cash market and the futures are trading at ₹990. An arbitrage fund short sells 10,000 shares of the company at ₹1,000 per share and simultaneously buys 10,000 futures at ₹990 per future. The fund receives cash proceeds of ₹1,000 × 10,000 = ₹1,00,00,000 from the short sale. From this, they pay ₹990 × 10,000 = ₹99,00,000 for the futures. The fund receives the shares on the future settlement day; the fund delivers the same to square up the short sale. The cash balance ₹1,00,000 minus expenses is passed on to the investors as gain.

What Are the Risks of Arbitrage Funds?

The future contracts are traded on the exchange, and hence, there is no counterparty risk. Exchanges will allow participants to sell futures only after ensuring that they can deliver the shares on the settlement date. (Even when there is a risk, it is usually borne by someone else, such as the broker or a lender. If the party who sold the future is unable to deliver the shares, their broker will ensure delivery and charge them for that in some way.)

Arbitrage funds are attracting more and more capital as awareness increases and investors prefer arbitrage funds over liquid or similar debt funds. When every arbitrage fund wants to buy futures, who would sell them? In addition to arbitrage funds, many AMCs are planning to start long-term debt funds that hold a minimum of 35% arbitrage. (Some AMCs already have such funds in the market.)

If there aren’t enough futures to buy, arbitrage funds cannot make money. A liquid fund can potentially hold a big chunk of its capital as cash if it runs out of bonds and papers to buy. An arbitrage fund is required to invest at least 65% of its capital in equity derivatives. Future volume has fallen in the past, but such episodes have been short-lived. It’s anyone’s guess what arbitrage funds will do if there aren’t enough futures to buy for an extended period of time.

Finally, arbitrage funds are allowed to hold bonds and money market papers for up to 35% of their AUM. Check the portfolio of your fund to make sure that you are comfortable with the credit quality and duration of the bonds they hold.

Alternatives to arbitrage funds

If you are not comfortable investing in arbitrage funds, you should consider mutual funds that invest in bonds and/or short-term papers. Liquid, money market, etc. are some popular categories with return/volatility characteristics similar to arbitrage funds.

I purposely wrote “volatility” in the previous sentence instead of “risk” because the risk profile of debt funds is different from the risk profile of arbitrage funds. While arbitrage funds may suffer if there is a shortage of futures in the market, there’s usually no shortage of bonds or short-term papers to buy.

Whether you invest in arbitrage or pure debt funds is a personal choice. Neither fund category is clearly better or worse. Consider all the factors and choose the option that you feel comfortable with.