An arbitrage fund is a type of mutual fund that appeals to investors who want to profit from volatile markets without taking on too much risk. Before investing in one, it is crucial to understand how they work and if they make sense for your portfolio.

KEY TAKEAWAYS

  • 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.

Arbitrage Funds: An Overview

Arbitrage funds work by exploiting the price differential between assets that should theoretically have the same price. One of the most important types of arbitrage takes place between the cash and futures markets. A typical fund purchases stocks with the hope of selling them later after the price has gone up. Instead, an arbitrage fund purchases stock in the cash market and simultaneously sells that interest in the futures market. The differences between stock prices and futures contracts are usually very small. As a result, arbitrage funds must execute a large number of trades each year to make any substantial gains.

The cash market price of a stock, also called the spot price, is what most people think of as the stock market. For example, suppose that the cash price of a share of ABC is $20. Then, you can purchase a share for $20 and own that portion of the company when the trade is executed.

The futures market is slightly different 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 of stock do not change hands immediately in the futures market. With futures, shares are transferred on the maturity date of the contract for the agreed price.

ABC might sell at $20 per share today, but perhaps the majority of investors feel ABC is primed for a spike next month. In that case, a futures contract with a maturity date one month down the road may be valued much more highly. The difference between the cash and futures price for ABC stock is called the arbitrage profit.

Arbitrage funds take advantage of these 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.

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 and then immediately sell it at $57.15 on the London Stock Exchange.

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.

Benefits of Arbitrage Funds

Arbitrage funds offer several benefits, including:

Low Risk

One of the chief benefits of arbitrage funds is that they are low risk. 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, the fund invests more heavily in debt. That makes this type of fund very appealing to investors with low risk tolerance.

Another significant advantage to arbitrage funds is that they are some of the only low-risk securities that actually flourish when the market is highly volatile. That is because volatility leads 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 are not exhibiting much change. When markets are calm, investors have no reason to believe stock prices one month in the future will be much different from the current prices.

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

Arbitrage funds are technically balanced or hybrid funds because they invest in both debt and equity, but they invest primarily in equities. 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.

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.

Drawbacks of Arbitrage Funds

Drawbacks that need to be considered include:

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.