For most investors volatility is the biggest evil of the stock market. Here is a fund, that offers cushion against market ups and downs in the near to medium future.

If you are an investor who can take moderate to low amount of risk, arbitrage funds could serve you in this regard.

So what is an arbitrage fund and what should investors look for in them? Investment Yogi explains it all.

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An arbitrage fund follows a strategy of buying and selling similar and equal securities simultaneously from at least two different markets. It takes advantage of the mispricing between two markets thus hedging against risk.

The profit would be the difference between the prices of the instrument in different markets.

For example: Let us consider the stock of ABC Ltd, which is being traded in the equity market as well as the derivative market at Rs 500 and Rs 520 respectively. The arbitrage transaction could involve:

Buy ABC Ltd. shares at Rs 500 per share in the equity market. At the same time, share of ABC Ltd. would be sold in the futures market, at Rs 520.

On the expiry date of the futures contract, the price of the equity shares and the stock futures, tend to coincide. You then offset the above two transactions by buying the contract in the futures market and selling the shares in the equity market.

Suppose, on this date, the share price is Rs 530, a profit of Rs 30(Rs 530 minus Rs 500) per share is made in the equity market and a loss of Rs 10 (Rs 520 minus Rs 530) is made in the derivative market.

The net gain is Rs 20.

If the share price falls to Rs 470, a loss of Rs 30 in the equity market and a profit of Rs 50 in the futures market is made.

Again, the net gain is Rs 20.

Irrespective of whether the share price of ABC Ltd has risen or fallen, the profit remains the same. As both the buying and selling transactions offset each other, they are not affected by market movements.

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Asset allocation in an arbitrage fund

Fund houses generally invest 65 per cent to 90 per cent in derivatives such as index futures, index options or stock options, and the remaining 10 per cent to 35 per cent in money market debt instruments or equity, depending on the scheme plan.

Why should you invest in an arbitrage fund

Arbitrage strategy reduces risk and delivers decent risk-adjusted returns in comparison to other short term debt funds, even in times of market volatility.

Taxed as equity funds, they offer a tax advantage over income funds.

Entry and exit load

There is no entry load. There is an exit load of around 0.25 per cent if you exit before six months. A STT (securities transaction tax) of 0.25 per cent is also levied.

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Drawbacks of the fund

Though the fund can be purchased any time, redeeming units happen only on the last Thursday of the month, that is, on the futures expiry date. For redemptions before that, money will be paid out only on or after that date.

Meaningful arbitrage opportunities in the market are not easily available. The fund house will have to be vigilant in identifying such opportunities.

A few funds invest in stocks at times when there are no lucrative arbitrage available. In such cases funds are exposed to the same risks as a diversified equity fund.

Sometimes, when the futures contract expires, the price of the stock in the cash and futures segments can have a slight difference in their prices. As a result, profit will be affected.

Each transaction in the stock market involves payment of brokerage and STT. These costs affect profits.

Arbitrage funds: Investors' perspective

Though marketed as risk-free investments by most fund houses, investors' reactions have been mixed.

Theoretically, these funds use the price difference between the equity and derivative markets to generate results. However, in reality, like all mutual funds, arbitrage funds have managed to generate high profits, mostly when the market has been in a rally.

For debt fund investors, arbitrage funds could prove to be a better option due to its tax benefit.

Keep in mind, no investment is totally risk free. Understand the risks involved before taking the plunge.