Can you earn returns or profits from market volatility?
There are various types of mutual fund schemes available in the market that are formulated according to the needs & goals of the investors.
Investors are of different types; some are aggressive with a higher risk appetite while others are risk-averse with a lower risk appetite. Other types include investors with moderate risk appetite or someone who wants to invest in a particular sector or index, etc. Mutual funds offer various types of schemes, depending upon the needs of the investors.
In the same way, if an investor wants to learn something from a volatile market, then where should they invest? Mutual fund offers arbitrage funds, which is a type of hybrid fund that assists investors to earn through volatility.
Arbitrage funds are the type of funds that generates profit out of market volatility. These funds leverage the price differential in the cash & derivatives market in order to generate returns. The simultaneous purchase & sale of an asset in order to make a profit from the difference in price is known as arbitrage. The fund manager of this fund also invests in debt/fixed income instruments as these are hybrid funds. Fund managers ensure that investment in debt should be a high-credit-rated debt instrument in order to keep the returns stable; in case, arbitrage funds are underperforming.
How do arbitrage funds work?
Let’s assume that the equity share of PQR Ltd is trading at Rs.1,500 & Rs.1,550 in the cash market and futures market, respectively. So, the fund manager purchases the shares of PQR Ltd at the rate of Rs.1,500 and arranges the contract to sell the shares at Rs.1,550. Here, towards the end of the month, when the prices match, then fund managers sell the shares in future markets and book the profit of Rs.50 per share while any cost involved will get deducted. On the contrary, if the fund manager thinks that price in future is going to fall, then he can enter into long contract in the futures market. The fund manager will then sell shares in the cash market at Rs.1,550 while at expiry, he purchases the shares at Rs.1,500 and makes a profit of Rs.50. Fund managers also take the benefit of the same equity share trading at different price levels on BSE & NSE. Let us assume that the stock of the company - XYZ Ltd is trading at Rs 65 at NSE and the same stock is trading at Rs.60 on BSE. So, in this case, the fund manager will buy the stock on BSE at Rs.60 and simultaneously, sells the same at Rs.65 on NSE. In this, the fund manager makes a risk-less profit of Rs.5 per share out of the differential in prices in different markets for their investors. These funds perform well when the market is highly volatile.
What things should investors know before investing?
Risk factor: These funds are less risky than other equity-oriented funds. As we have seen in the above paragraphs, fund managers try to generate alpha for their investors. Investors should invest in these funds according to their needs and goals.
Returns: Returns are not as exceptional as other equity-oriented funds. One-year returns of these funds vary around 3 per cent-4 per cent while 5-year returns vary around 5 per cent-6 per cent.
Cost: These funds incur fees i.e. expense ratio, which is percentage of the fund’s overall assets. These funds include fund manager’s fees, fund management fees, etc. Due to regular trading, transaction cost is also incurred.
Investment horizon: Investors having short-term or moderate-term investment horizon should invest in these funds. Short-term means investment horizon of at least 3-6 months while medium-term includes horizon of at least of 3-5 years.
The following graph depicts the 1-year & 5-year return of the top five arbitrage funds based on their AUMs as of 30 June 2021:
