How do I pick the right arbitrage fund? Does AUM size matter for returns?

You should pick an arbitrage fund based on its fully hedged purity, low expense ratio, high-quality debt portfolio and a moderately sized AUM.

Since all arbitrage funds run the same basic strategy of capturing price spreads you have to look at the finer details. First and foremost you have to look at the expense ratio. Arbitrage operates on very thin margins and typically generates single-digit returns.

Because the gross returns are relatively low any high fees will severely eat into your net profit. Always opt for a direct plan to keep the Total Expense Ratio or TER as low as possible.

Next you need to check the purity of the fund. A true arbitrage fund should have its equity positions completely hedged in the futures market. You must ensure the fund does not carry any unhedged directional equity exposure which would completely change its risk profile.

Then you have to look at the debt portfolio quality. Arbitrage funds often park around 20% to 25% of their money in debt mutual funds or short-term papers. It is vital to assess the credit rating of these underlying debt papers to ensure no undue credit risk is being taken.

Finally let us talk about Assets Under Management or AUM. Size actually matters a lot in arbitrage but bigger is not always better. A fund with an excessively large AUM might struggle to find enough arbitrage opportunities in the market to deploy all its capital efficiently.

Conversely a very small AUM fund might suffer from high impact costs when buying and selling. A moderately sized AUM is generally the sweet spot for this specific category.

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