Should you invest in Arbitrage funds?

Now that the markets are at their peaks and the valuations appear to be stretched, retail investors have a reason to be wary of entering the markets directly in the stock market or indirectly through the mutual fund route. So what should the retail investors do in such a market? Just sit on the sidelines and wait for the markets to correct or enter the markets now hoping that the markets would go up from here assuming the rally is not yet over? Neither of these two options are good enough to warrant consideration. In such a market scenario, the investors can consider investing in arbitrage funds that are purely ‘opportunistic’ in nature. So what are these arbitrage funds and how do they work?

Arbitrage funds are equity-oriented schemes that try to capitalise on the difference in the prices of stocks or index derivatives in two different markets and market segments. The fund managers of arbitrage funds buy the stock or the index futures in one market and simultaneously sell it in another market or market segment to gain out of the mispricing. Since the fund manager buys and sells the same security at two different price levels, the position is hedged, which greatly diminishes the risk. The fund managers of arbitrage funds always look out for such opportunities that markets throw up every day and take advantage of the differential pricing in different markets or market segments to make profit. Such short-term opportunities arise due to lack of information among market participants in either of the two markets.

The arbitrage funds are tax-efficient too as gains made on arbitrage fund units held for more than one year are tax-free. If the units are held for less than a year, short term capital gains tax of 15% (plus surcharge and cess) would be applicable.  The returns on these funds depend as much on market conditions as on the ability of the fund manager to cash in on the arbitrage opportunities that the markets throw up.