All you wanted to know about arbitrage funds

How about earning high returns from the stock market without bearing any risk? Surprised, aren't you? But, yes, it is true. There is something called as arbitrage that lets you eliminate risk from stock marketing investing.

Fund houses have latched on to this strategy and introduced arbitrage funds. They have marketed these funds as "risk-free". But are they really risk-free? Is there no likelihood of suffering a loss by investing in these funds?

Introduction to arbitrage

Arbitrage is a strategy that consists of concurrent buying and selling of equal or comparable securities from at least two markets in order to profit from the variation in their prices.

What makes this strategy risk-free is the fact that both buy and sell transactions precisely balance each other, thus making them invulnerable to market swings. But this is a myth, as we shall see later on.

Arbitrage strategy demystified

There are many types of arbitrage strategies. Buying stock and selling in future is the most widely used arbitrage strategy in India. This happens when there is a significant difference in the price of the stock in cash market and its price in the futures contract.

Usually the price of the stock is lower in the cash segment as compared to its price in the futures contract.

So buying in the cash segment and selling in the futures segment allows you to profit from the price difference in both the segments. On or prior to the expiry date of the futures contract (final Thursday of each month), this difference reduces, and the position is unwound, thus booking profit. For example, if the price of a stock in cash segment is Rs 200 and in futures segment is Rs 250, the profit of Rs 50 is already locked when the transaction commences.

At the time of expiry, their prices become Rs 275. Now the position is unwound, meaning selling stock and buying future, giving a profit of Rs 25.

As futures are always traded in lots, if this future lot has 100 shares, the total profit earned is Rs 2,500. This is the strategy followed by arbitrage funds to generate higher returns for their investors.

Is the strategy safe

If earning Rs 2,500 irrespective of the market fluctuations without having to bear any unwarranted risks was so easy, then all of us would have been millionaires. But this is not true. These are some of the important factors that can make this strategy very risky.

• Arbitrage funds rely heavily on the availability of arbitrage chances in the market. However as of now, there are very limited number of stocks available for trading in the derivatives market, thus providing a restricted scope for stock selection and greatly reducing arbitrage prospects. Moreover in an extended bear phase the price of the stock in future is lesser than in cash segment, thus nullifying this strategy.
• Certain funds have an authorization to go for stocks in case there are no lucrative arbitrage chances. These funds then are exposed to the same risks as a normal diversified equity fund, making them significantly risky.
• When the futures contract expires, it not mandatory for the price of the stock in the cash and futures segments to meet. There can be a slight difference in their prices. As a result, your profit will be affected. So remember the likelihood of fund generating higher return is as same as it failing to generate expected return.
• Liquidity can also affect arbitrage funds. As futures are traded in lots, one lot will have numerous shares of a company. A fund manager may not be able to buy the required number of shares at a predetermined price.

For example, if the futures lot of company A contains 200 shares, it can be difficult to get these 200 shares at the same price. Normally future contracts are squared-off automatically on the date of expiry.

However the shares purchased as a part of  the arbitrage strategy must be sold before the market close on the day of expiry. But if there is insufficient liquidity in the stock and all the stocks purchased against its future contracts remain unsold, it can impact the fund's performance and may lead to losses for the fund.

Agreed, arbitrage funds are comparatively risk-free than normal diversified funds. But they are not totally risk-free. So you need to be aware of the risks of these funds before investing.

Remember no investment is completely risk-free. Understand the risks of these funds before investing in them. If you cannot fathom them, stick to plain diversified funds.