Are arbitrage funds actually risk-free? Planning to move Rs 50L from my savings account.

While arbitrage funds are very low-risk because they hedge their equity exposure, they are not entirely risk-free and can occasionally face negative spreads or credit risks.

It helps to understand how they actually generate returns in the first place. At its core, arbitrage is just capturing the price difference of the same asset across two different markets. Think of a local vegetable market where you buy tomatoes from one vendor at Rs 35 and walk 700 meters down the road to sell them for Rs 40.

You just locked in a risk-free profit of Rs 5. In the stock market, a fund manager does this by buying a stock in the cash market at say Rs 100 and simultaneously selling it in the futures market at Rs 105. Because they take opposite positions, the portfolio is completely hedged against market movements.

However, there are a few specific risks you need to be aware of. The first is the risk of negative spreads. Usually, futures prices are higher than spot prices, but during extreme market panic like the Covid crash, futures can actually trade at a discount.

When spreads go negative, the fund might deliver sub-optimal or even temporarily negative returns for a short period. The second thing to watch out for is credit risk. Arbitrage funds do not just trade equities, but they also park a portion of their corpus in debt mutual funds or fixed-income securities.

Some funds might compromise on the credit quality of that debt portion to boost their yields. You always want to ensure the fund sticks to high-quality AAA or A1+ rated papers.

This is why the ideal minimum holding period for an arbitrage fund is 3 to 6 months. Giving it that 3 to 6 month window allows enough time to smooth out any short-term volatility and generate consistent positive returns.

Disclaimer: All information shared above are strictly for educational and informational purposes only. It should not be construed as financial or investment advice.