Arbitrage funds seek to generate low volatility returns. They use the price differentials of a product in different markets. The fund invests both in equity markets as well as in short-term debt instruments like treasury bills, bonds, certificate of deposit, etc. The equity portion of the fund is hedged using derivatives like futures contracts. The fund manager strives to take advantage of the price differential in different markets like the cash and the derivatives segment.

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Let me take you through an example for a better understanding:

Mr Ravi Agarwal runs a fast food joint serving delicious burgers. He sells burgers at Rs 50 per piece. He incurs a cost Rs 30 to make these burgers. Hence, the net profit earned by him stands at Rs 20 (Rs 50- Rs 30). He wants to increase his profit margins without increasing the selling price.

One morning he tried burgers at a bakery near the railway station. He found strong resemblance in its quality and taste. However, the burger was available for only Rs 20. So, he came up with an idea. He contracted with the bakery to buy its burgers at Rs 20. Thus, his profit swelled to Rs 30 (Rs 50- Rs 20) per unit.

The investment mechanism involves a simultaneous purchase of shares and sale of futures of the same company. This process continues till the futures trade at a reasonable premium. The profit owing to mis-pricing of securities is caused by uneven market knowledge. However, as the market knowledge becomes widely accessible, the price advantage ends. Arbitrage opportunities are, thus, said to be short-lived.

Lets continue with the above example for a deeper insight.

Suppose Ravis customers come to know about the cheap burgers near the railway station. Gradually most of them start having burgers at the bakery instead of Ravis joint. Looking at the increased footfalls, the bakery owner raises the price of the burger to Rs 40. Now, Ravi doesnt find it profitable to buy burgers from the bakery. It is because his profit falls to Rs 10 (Rs 50- Rs 40). It ends the price advantage enjoyed by Ravi.

Apart from the temporary price advantage, arbitrage funds have other unique attributes. The fund manager refrains from taking unhedged equity exposures. He doesnt want to increase the risk profile of the portfolio. It is assumed that the cash and futures price would coincide on expiry. It will thereby generate positive returns for the investor. It would be highly beneficial if you stay invested till maturity of the derivative contract. Hence, unlike open-ended debt funds, you cant redeem at a profit as per your discretion.

Let me take you through an example of an arbitrage fund transaction:

Suppose at the beginning of July, Fund A buys XYZ Ltd. shares for Rs 1,500/share and sells XYZ July futures at Rs 1560.

Arbitrage funds are for conservative investors having an investment horizon of 1 to 3 years. Investors having a horizon of extremely short duration say less than 6 months; arbitrage funds wont be the best bet. In that case, you may try your hands on debt funds. It was found that for such duration, ultra-short term funds gave higher returns than arbitrage funds.

Arbitrage funds are one of the favourably taxed categories of mutual funds. These funds offer returns comparable to a debt fund but tax treatment like equity funds. The dividends distributed by arbitrage funds are tax-free both in the hands of investor and the fund house.

As arbitrage funds usually maintain equity exposure of more than 65%, they are treated as equity funds. It ultimately has important tax implications for both short-term and long-term. If you redeem your investments before 1 year, the short-term capital gains would be taxed at 15%. Additionally, the interest earned on fixed income securities would be taxable as per your income tax bracket.

Conversely, if you redeem your investments after 1 year, the long-term capital gains would be tax-free like equity funds.

Also read:Capital Gains: The long & short of it

The general investor perception about arbitrage funds being all weather birds needs a relook. These funds leverage on the mispricing of securities. During bull runs, the probability of mispricing increases on account of high volatility. Moreover, the futures tend to be priced higher than the cash segment i.e. equities. Consequently, investments in stocks in portfolio stand to gain. The fund managers sell the futures and buy the stock in the cash market thus booking risk-free return.

During bear runs, futures tend to be priced at a discount i.e. below the stock price. The arbitrage opportunity hence disappears.

Selecting the right arbitrage fund is all you need to maximize your risk-free returns. Along with qualitative factors like fund history, you need to probe other quantitative factors as well. The table below shows the top picks of the season based on in-depth analysis of risk-return factors.

The rationale of considering each of the factors is explained as follows:

It is believed that the longer the existence of a fund in a particular sector, the richer would be its investing experience. Herein, funds having a history of at least 5 years have been considered. You may go for longer histories as well.

Funds giving higher returns at time intervals of 3 years and 5 years are regarded superior and thus taken into the list.

It creates a charge on funds Asset under Management. Fund having a lower expense ratio is better positioned to give higher returns than a fund with a higher expense ratio.

As the fund manager aims at low volatility returns; these funds have a low standard deviation. A fund with a lower standard deviation is regarded as giving consistently higher returns as compared to highly volatile funds.

Funds having higher Sharpe Ratio are better at giving higher risk premium or risk-adjusted returns as compared to funds with lower Sharpe Ratio.

Funds with a beta less than 1 have low relative volatility compared to funds with a beta higher than 1.

Funds with the higher alpha are superior to funds with lower alpha. They indicate the contribution from the fund manager towards the growth in NAV.

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Kotak Equity Arbitrage Fund-Regular Plan looks the best bet regarding risk-adjusted returns, consistency and alpha. It has given consistently higher low volatility returns. Moreover, it has a moderate expense ratio. Reliance Arbitrage Advantage Fund stands to be the riskiest investments amongst the five. It has the highest SD and highest relative volatility of 1. It means that its potential to emulate the market returns is high. Its suited for investors who take the relatively higher risk than others.

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