Definition: The Arbitrage Funds are the equity-based mutual funds that try to take the advantage of price differentials (of the same asset) in the cash and derivative markets to generate returns. Simply the funds that generate money from the difference in the price of the same security in different markets are called as arbitrage funds.
The fund manager checks the difference in the price of security in the cash or derivatives markets or even on different stock exchanges such as BSE, NSE. Suppose, the price of stock in the cash market quotes Rs 120 and Rs 115 in the derivatives market. Then the fund manager would buy the stock from the derivatives market at Rs 115 and sell it in the cash market for Rs 120, thereby making a profit of Rs 5 per share for the investor.
The arbitrage funds are more suitable for the volatile markets where the fund manager can capitalize on differences in the price of securities in different markets. These funds are hybrid in nature since these offer an opportunity for the investor to concentrate the significant portion of his investments in the debt instruments. Often the fund manager uses the fixed income instruments (debt) to hedge against the equities.
Often the low risk taking investors invests in the arbitrage funds. These funds are considered more secure at the time of high and persistent volatility in the broad market. As these funds make a significant investment in equities, their tax treatment is similar to the equity funds and, therefore, enjoy the benefits of zero taxes on the long-term gains.