Arbitrage Mutual Funds: Benefits and Drawbacks

Arbitrage funds are a type of mutual fund that are appealing 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.

Arbitrage funds work by exploiting the price differential between the cash and futures markets. Rather than purchasing stocks and then selling them later after the price has gone up, for example, an arbitrage fund purchases stock in the cash market and simultaneously sells that interest in the futures market. Typically, the differences between stock prices and futures contracts are marginal, so arbitrage funds must execute a large number of trades each year to make any substantial gains.

The price of a stock in the cash market, also called the spot price, is what most people think of when they refer to the stock market. For example, if the cash price of a share of ABC is $20, then you can purchase a single share of stock for $20 and own that slice of the ownership pie as soon as the trade is executed.

The futures market is slightly different because it is a derivatives market. Instead of futures contracts being valued based on the current price of the underlying stock, they reflect the anticipated price of the stock at some point in the future. On the futures market, shares of stock do not change hands immediately, but are transferred on the maturity date of the contract for the agreed price.

ABC might sell at $20 per share today, but if the majority of investors feel ABC is primed for a spike, 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, therefore, take advantage of this differential by buying stock in the cash market and simultaneously selling a contract for the same number of shares on the futures market if the market is bullish on the stock. If the market is bearish, where the majority of investors believe the stock's price will drop, then arbitrage funds purchase the lower-priced futures contracts and sell the same number of shares on the cash market for the higher current price.

Arbitrage funds may also profit from trading stocks on different exchanges, such as purchasing a stock at $57 on the New York Stock Exchange and then selling it for a $57.15 on the London Stock Exchange.

Assume the spot price of ABC stock is $20 per share in the cash market, meaning its current value per share. But because the market is bullish on ABC, the price is up to $22 for a futures contract that matures in one month. This simply means the general consensus is ABC will gain at least $2 within the coming month.

Securities in the futures market are not sold individually. It is not possible to buy a contract for a single share. The standard size for futures contracts is 100 shares, so to execute an even-sided arbitrage trade, the fund must purchase 100 shares of ABC stock in the cash market for a total outlay of $2,000. At the same time, the fund sells a single futures contract, which is equivalent to the right to purchase 100 shares at contract maturity, for the higher price with a total sales price of $2,200. With two well-timed trades, the fund generates $200 in profit.

Arbitrage funds offer a number of benefits, including:

Low Risk

One of the chief benefits of arbitrage funds is they are low risk. Because each security is bought and sold simultaneously, there is virtually none of the risk involved with longer-term investments. In addition, arbitrage funds 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. This makes this type of fund very appealing to investors with low risk tolerance.

Another big advantage to arbitrage funds is they are some of the only low-risk securities that actually flourish when the market is highly volatile. This is because volatility leads to uncertainty among investors. The differential between the cash and futures markets is exaggerated. A highly stable market means individual stock prices are not exhibiting much change. Without any discernible bullish or bearish trends to either continue or reverse, 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 either. Arbitrage funds are a good choice for cautious investors who still want to reap the benefits of a volatile market without taking on too much risk.

Taxed As Equity Funds

Though arbitrage funds are technically balanced or considered hybrid funds because they invest in both debt and equity, they invest primarily in equities by definition. Therefore, they are taxed as equity funds since long equity represents at least 65% of the portfolio, on average. 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, which is much lower than the ordinary income tax rate.

[Important: Depending on your specific investment goals and risk tolerance, bond, money market, or long-term stock funds may be more stable options that can provide consistent annual income or steady growth without the roller coaster ride of arbitrage funds or aggressively managed equity 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. This 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 that successful arbitrage fund management requires means the expense ratios for these types of funds 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.

• Arbitrage funds can be a good choice for investors who want to reap the benefits of a volatile market without taking on too much risk.
• Though they 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.