Arbitrage Funds: How they profit from market gaps?

We will look at what arbitrage funds are and how these funds could generate better returns than fixed deposits.

The Story

Imagine you want to buy shares of ONGC Ltd. You open your stock broking app and search. Two quotations appear on your screen.

One from the Bombay Stock Exchange (BSE), and one from the National Stock Exchange (NSE). You, being a good observer, notice that there’s a slight price difference between quotes provided by the two exchanges.

Price of ONGC Ltd on BSE and NSE just before the market close.

You, also being a smart person, think of an idea. What if you buy the shares on one exchange, where the price is lower, and immediately sell on another exchange at a higher price? Well, that’s what we call arbitrage. It is a financial strategy that involves buying and selling the same asset in different markets to profit from price differences.

In simple words, you buy where the price is lower and sell where the price is higher, but in financial markets, such as stock exchanges.

If you’re wondering, how is it even possible? Well, you’re right. In a perfect world, arbitrage opportunity should not exist. It lets you earn money without facing any risk and with virtually no cash outlay because you buy and sell at the same time. That’s what these mutual funds do. Exploit market inefficiencies to earn risk-free profit.

Advantages of Arbitrage Strategy

1. Low Risk:
Arbitrage funds primarily rely on price differences, market volatility does not affect them much.

2. Liquidity:
Unlike fixed deposits with early withdrawal penalties, arbitrage funds offer liquidity with usually no exit fee if you withdraw fifteen days after investing.

Disadvantages of Arbitrage Strategy

1. Dependence on Market Conditions:
Arbitrage opportunities are more prevalent in volatile markets and are limited in stable markets, making the returns from these funds unpredictable.

2. Short-Lived Opportunities:
The returns depend on the number of arbitrage opportunities present in the market and the fund manager’s expertise in capitalizing on these opportunities. Because these opportunities exist for brief periods.

To conclude

Arbitrage funds can be a smart alternative for those looking to earn better returns than fixed deposits without taking on significant risks. However, their unpredictable payoffs mean that returns can vary based on market conditions and the fund manager’s skill.