Mutual funds are popular investments. They give investors exposure to a wide variety of assets by pooling together money from different investors and purchasing stocks, bonds, and other securities. Funds are managed by portfolio or money managers who try to generate gains or income for their investors. Fund portfolios are designed to match their goals and objectives.

One type of mutual fund is the arbitrage fund, which aims to buy and sell securities in different markets. This allows individuals to profit from any slight price differentials in these markets. Sounds good right? Before you decide to invest in one, it is crucial to understand how arbitrage funds work and if they make sense for your portfolio.

Key Takeaways

  • An arbitrage fund is a type of mutual fund.
  • Arbitrage funds can be a good choice for investors who want to profit from a volatile market without taking on too much risk.
  • Although arbitrage funds are relatively low risk, the payoff can be unpredictable.
  • Arbitrage funds are taxed like equity funds.
  • Investors need to keep an eye on expense ratios, which can be high.

What Are Arbitrage Funds?

Most mutual funds purchase stocks with the hope of selling them after the price has gone up at a later date. Although they are a type of mutual fund, that's now how arbitrage funds work. They appeal to investors who want to profit from volatile markets without taking on too much risk.

Arbitrage funds profit on price differentials in different markets. They may purchase stock in the cash market and sell that interest in the futures market. That's because the most important types of arbitrage occur between these two markets, albeit very small. As a result, arbitrage funds must execute a large number of trades each year to make any substantial gains.

Arbitrage in the Cash and Futures Markets

The cash market price of a stock (the spot price) is what most people equate to the stock market. For example, suppose that the cash price of one share of ABC Company sells for $20. You can purchase a single share for $20 and own that portion of the company when the trade is executed. Similarly, buying 20 shares for $400 means you own 20 shares worth of ABC Company after your purchase.

The futures market is slightly different. That's because it is a derivatives market. Futures contracts are not valued based on the current price of the underlying stock. Instead, they reflect the anticipated price of the stock at some point in the future. Shares don't change hands immediately in the futures market. With futures, shares are transferred on the maturity date of the contract for the agreed price.

Index Arbitrage

Index arbitrage is another popular type of arbitrage. In this case, an arbitrage fund might seek to profit by buying shares of an exchange traded fund (ETF) that is selling for less than the value of the underlying stocks.

The arbitrage fund would then immediately redeem the ETF for shares of stock and sell them to make a profit. The fund must be an authorized participant in the ETF market to use this strategy.

Arbitrage funds exploit the price differential between assets that should theoretically have the same price.

Example of Arbitrage Fund

Remember that arbitrage funds take advantage of different prices. They buy stock in the cash market and simultaneously sell a contract for it on the futures market if the market is bullish on the stock. If the market is bearish, then arbitrage funds purchase the lower-priced futures contracts and sell shares on the cash market for the higher current price.

Let's go back to that example of ABC Company from above. The company's stock might sell at $20 per share today, but the majority of investors may feel it is primed for a spike next month. In that case, a futures contract with a one-month maturity date may be valued much more highly. The difference between the cash and futures price for ABC stock is called the arbitrage profit.

Arbitrage funds may also profit from trading stocks on different exchanges. For example, they might purchase a stock at $57 on the New York Stock Exchange (NYSE) and then immediately sell it at $57.15 on the London Stock Exchange (LSE).

Depending on your specific investment goals and risk tolerance, bond, money market, or long-term stock funds may be more stable and consistent than the roller coaster ride of arbitrage funds.

Benefits of Arbitrage Funds

Arbitrage funds offer several benefits, including a low level of risk and special tax treatment. Let's take a quick look at these two benefits and how they relate to arbitrage funds.

Low Risk

Arbitrage funds generally come with a low level of risk to the investor. Because each security is bought and sold simultaneously, there is virtually none of the risk involved with longer-term investments.

Arbitrage funds also invest part of their capital into debt securities, which are typically considered highly stable. If there is a shortage of profitable arbitrage trades, funds invest more heavily in debt. That makes this type of fund very appealing to investors with a low tolerance for risk.

These funds are some of the only low-risk securities that actually flourish during times of high market volatility, which can lead to uncertainty among investors. The differential between the cash and futures markets increases when prices are unstable. A highly stable market means individual stock prices don't exhibit much change. When markets are calm, investors have no reason to believe stock prices will be much different from the current prices a month in the future.

Volatility and risk go hand in hand. You cannot have huge gains or huge losses without volatility. Arbitrage funds are a good choice for cautious investors who want to benefit from a volatile market without taking on too much risk.

Taxed as Equity Funds

Although they invest primarily in equities, arbitrage funds are technically balanced or hybrid funds because they invest in both debt and equity. Therefore, they are taxed as equity funds since long equity represents an average of at least 65% of the portfolio.

If you hold your shares in an arbitrage fund for more than a year, then any gains you receive are taxed at the capital gains rate. This rate is much lower than the ordinary income tax rate.

Drawbacks of Arbitrage Funds

Just as with any other investment, there are certain downsides to investing in and keeping them in your portfolio. Here are some of the most common disadvantages.

Unpredictable Payoff

One of the primary disadvantages of arbitrage funds is their mediocre reliability. As noted above, arbitrage funds are not very profitable during stable markets. If there are not enough profitable arbitrage trades available, the fund may essentially become a bond fund, albeit temporarily.

Excessive time in bonds can drastically reduce the fund's profitability, so actively managed equity funds tend to outperform arbitrage funds over the long term.

High Expense Ratios

The high number of trades required by successful arbitrage funds means their expense ratios can be quite high. Arbitrage funds can be a highly lucrative investment, especially during periods of increased volatility. However, their middling reliability and substantial expenses indicate they should not be the only type of investment in your portfolio.

The Bottom Line

There's probably a very good chance that you haven't heard of arbitrage funds. That's because they aren't like your typical mutual funds. Unlike other funds, arbitrage funds place large orders and capitalize on price differentials for the same security in different markets. This allows investors to profit from market volatility without taking on too much risk. Although they may sound appealing, it's always a good idea to sit down with a financial professional to discuss how arbitrage funds may fit into your investment portfolio.