Last Updated on
Arbitrage mutual funds are typically as volatile as ultra-short-term debt mutual funds. However, when market turbulence increases, they become more volatile. This may or may not result in more returns. Here is why this happens.
As the name suggests, an arbitrage mutual fund invests in arbitrage opportunities (min 65%). This means, they and sell the same stock or bond in different markets. For example in the cash market and in the futures market.
The cash market is where we buy and sell stocks with a demat account as the current market price. In the futures market, the buyer and the seller do not exchange stocks (or commodity) immediately. The stocks change hands at a future date, but the price is fixed at the time of the agreement.
A difference between the stock price in the futures market and the spot market is referred to as an arbitrage opportunity. This difference arises due to the inefficient flow of information between the two markets and is temporary.
As the due date of the futures contract expiry nears, the difference decreases and the prices tend to become the same. More arbitrage opportunities are available when the markets are volatile.
If the futures stock price is lower than the spot market price, people would prefer the former. The increased demand will increase the futures stock price. There would also be pressure on the spot stock price to decrease. Soon the two prices will converge.
Thus although the difference in price (arbitrage opportunity) may exist at one point in time, it will diminish rapidly. For an example of how mutual funds profit from this see, How Arbitrage Mutual Funds Work: A simple introduction
The 30-day rolling volatility (standard deviation) of ICICI Equity Arbitrage Fund is shown below. Notice the sharp increase in volatility over the last couple of weeks.
This essentially means the NAV moves up and down a lot more violently. An increase in market volatility also increases the gap between cash and futures market. They may also not converge as efficiently as before. Decreased participation from foreign portfolio investors may result in domestic investors getting a bigger chunk of the arbitrage pie.
While the increased volatility could mean a bit more returns, they are certainly not guaranteed and they certainly should not last for long. Over a year or more it should not make a big difference. Investors should not flock to arbitrage funds on the basics of short-term volatility. Existing investors also need not fear it but must be prepared for some big swings in NAV.
Please note, arbitrage funds, in general, should not be used for durations less than a year in any market.
About the Author
M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin
Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy
Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google NewsFreefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication.Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via: Feedburner
Our Publications
You Can Be Rich Too with Goal-Based Investing
This book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earnerYour Ultimate Guide to Travel
Free Apps for your Android Phone
- All calculators from our book, “You can be Rich Too” are now available on Google Play!
- Install Financial Freedom App! (Google Play Store)
- Install Freefincal Retirement Planner App! (Google Play Store)
- Find out if you have enough to say "FU" to your employer (Google Play Store)
