Investors in recent times have come across a new category of mutual fund offerings - UTI Spread Fund, Tata Equity Management Fund, J M Arbitrage Fund. These funds, popularly known as Arbitrage Funds or Derivative Funds are recognised for modest and secured returns across the world and are comparatively safer investment option when compared with equity funds. Arbitrage in the financial parlance is the practice of taking advantage of a state of imbalance between two or more markets i.e. it involves buying and selling of equal quantities of a security in two different markets with the expectation that a future change in price in one market will be offset by an opposite change in the other. One of the markets is usually cash or spot, while the other is derivatives.
With SEBI allowing the full-fledged participation of mutual funds in derivatives and recent turbulence witnessed in the equity markets fund managers are now hunting grounds with arbitrage funds and rightly so as such investment options provide risk free returns least affected by the market movements and suffices the needs of conservative investors. As these funds are centered on price difference between the spot and futures markets such price differences provide huge opportunities for generating returns from equity without taking the risks involved in equity investments.
How does it work? Position in a stock is created in the spot or cash market and a reverse position in the same stock in the futures contract (a contract which obligates the buyer to purchase or seller to deliver at a future date at a determined price).

Let us consider an example. If the price is higher in futures market than the spot market, the fund will buy the stock in spot market and sell it in equal quantity in the futures market simultaneously. To illustrate, if the price of a stock is Rs 100 in the spot market and the month end future price is Rs 120. The scheme would enter into the following trades: Purchase 1000 shares (Rs 100 per share) at the total cost of Rs 1 lakh and sell 1000 futures of the same stock (Rs 120 per share) at the sale proceeds of Rs 1.2 lakh. The trade is done to lock in profits of Rs 20000 irrespective of the movements in the stock price.

Also let us assume that the price of the stock has gone down to Rs 95 by the end of the month. That would mean a loss of Rs 5000 {1000* (95-100)} in the spot market and a profit of Rs 25000 {1000*(120-95)} in the futures market. That is a net profit of Rs 20000 for the scheme. Alternatively, if the price goes up to Rs 125, that would result in a net profit of Rs 25000 {1000 * (125-100)} in the cash market and a loss of Rs 5000 {1000*(120-125)} in the futures market. That is again a profit of Rs 20000 for the scheme. By doing this fund is insulated against price variations in the stock prices in both cash and derivative markets.
Here the return of the fund is thus linked to the extent of arbitrage opportunity; regardless of what direction and to what extent the market rises or falls. Though it cannot generate the kind of returns that an equity fund can but will not give negative returns either. Also being coming under the category of equity funds post tax returns enhances in such funds compared to the debt funds.
There is no denying that such funds provide good hedge against volatile markets but the concern is that investment opportunities catering to the mis-pricing of securities in different markets to generate returns may be few and difficult to spot and would require the fund managers to be very active; alternatively, simultaneous trade in various markets which may increase transaction cost and portfolio turnover rate. And in a period when no or few arbitrage opportunity is available the fund will have to rely upon the fixed income instruments which may dampen the returns. Also arbitrage activity in India is largely concentrated in some of the stocks.
Extending the basic fundamental features of mutual funds to various forms of investments through innovative measures has remained the specialty of mutual funds and is good sign for any industry to evolve. Mutual Funds have often been considered a good route to invest and earn returns with reasonable safety. And now it is bestowed upon mutual funds how they create value for the investors and set new precedents here as well.