As a strategy, arbitrage involves simultaneous purchase and sale of identical or equivalent instruments from two or more markets in order to benefit from a discrepancy in their prices. What leads (or rather misleads) everyone to believe that arbitrage funds are risk-free is that, in arbitrage strategies, both the buying and selling transactions exactly offset each other (supposedly), thus making it immune to the market movements.

That is, regardless of stock market fluctuations, the fund will not get impacted. The profit in arbitrage strategy is the difference between the prices of the instrument in different markets (like cash and derivative markets for instance).

The truth however is that arbitrage funds are not risk-free. Where does the risk lie? Well, factors like the availability of arbitrage opportunities, their 'perfect' execution and also the liquidity in the stock/cash and futures segments are some of the factors that contribute to the uncertainty, and therefore risk, with respect to this investment avenue.

The most common arbitrage
Buy stock - sell future is the most commonly used arbitrage strategy in the Indian context. Such an arbitrage opportunity arises when the price of a stock (in stock/cash/spot market) trades at discount to the price of its future contract (in futures/derivatives segment).

Thus, one can buy the stock from the cash market at lower price and sell its future contract at a higher price, the profit being the difference between the future price and cash price. On or before the expiry date (last Thursday of every month), the difference between the spot and futures price narrows. The position is then unwound to book the profit.

Illustration
For example, as a part of the arbitrage strategy, a stock 'A' is bought at Rs 100 and its future is sold at Rs 105, thus locking a return of Rs 5 at the time of initiation of the trade. By the end of the expiry, their prices converge to Rs 110.

On unwinding the position (sell stock-buy future), the profit earned on the stock from the stock market is Rs 10, while the loss from the future market is Rs 5. Therefore, the net profit realised is Rs 5 (which was actually locked-in during the initiation of the trade). Future contracts are always traded in lots. Therefore, if the future contract of stock 'A' has a lot size of 100 shares, then, the total profit/return made on this strategy will be Rs 500.

Betting on the right scenario
A profit/return of Rs 500 regardless of the market movement sounds lucrative. If it was possible, then we would all be taking up arbitrage as a career! The above-mentioned illustration of a common arbitrage strategy is an ideal situation; but ideal situations do not exist.

Moreover, several other scenarios, which are unknown to investors, can have a significant bearing on the final result (the profit). We present here some of these factors, which investors must look at before committing monies to arbitrage funds.

Arbitrage funds depend heavily on the availability of arbitrage opportunities in the market. With only 187 stocks currently permitted to trade in the derivatives market, these funds have a limited scope in terms of stocks, for finding enough arbitrage opportunities.

Also, a prolonged bear phase may pose opportunity crunch for the arbitrage fund. The arbitrage strategy of buy stock - sell future will not work if the future price of the stock is trading at a discount to its spot price, which is fairly common during a bearish phase.

Some funds have a mandate to invest only in stocks in the absence of an attractive arbitrage opportunity. In that case, the fund will become susceptible to the same risks as a conventional diversified equity fund. This will increase the risk profile of the arbitrage fund significantly.

There are certain factors related to the execution of the arbitrage strategy that must be considered. On the date of expiry, when the arbitrage is to be unwound, it is not necessary for the stock price and its future contract to coincide. There could be a discrepancy in their prices even a minute before the market closes. Thus, there is a possibility that the arbitrage strategy gets unwound at different prices.

For understanding this, let's go back to the above illustration, where a stock 'A' is bought at Rs 100 and its future is sold at Rs 105. Now, at the time of unwinding the position (on the expiry date), if the stock 'A' is trading at Rs 106 and its future contract is trading at Rs 108, the profit on stock 'A' is Rs 6 (106-100) whereas the loss on its future is Rs 3 (108-105). Therefore the net profit will be Rs 3 (6-3) and not Rs 5, which would have been in an ideal situation.

Given that the possibility of the fund garnering a higher return (i.e. more than Rs 5 in our illustration) cannot be ignored, there exists almost equal chance of the fund falling short on the return front.

Arbitrage funds can also get impacted by lower liquidity in the spot/future segment. Future contracts are always traded in lots i.e. one lot of a future contract of a particular stock will have multiple shares. To give an idea, currently, one lot of Divi's Laboratories Ltd. future comprises 62 shares, while that of Nagarjuna Fertilizer & Chemicals Ltd. has 14,000 shares.

Therefore, if an arbitrage opportunity arises in Nagarjuna Fertilizer, the fund manager will have to buy 14,000 shares of the company from the stock market and sell one lot of its future contract. Further, if the fund manager decides to sell, say, 30 lots, he has to purchase 420,000 shares from the stock market. The fund manager may not be able to purchase the desired number of shares at the given price.

Future contracts usually get squared-off automatically at the expiry date. But the shares bought as a part of the arbitrage strategy have to be sold before the market closes on the expiry date. If for some reason, there isn't adequate liquidity in that stock, and all the stocks (bought against its future contracts) cannot be sold, it may prove detrimental to the fund's overall performance.

It may also eventually lead to the fund making losses on that arbitrage position, if the stock could not be sold completely and the entire profit could not be booked. On the other hand, the short position on its future contract (which is incurring losses) must be squared-off, as it cannot be carried forward to the next month because of lack of opportunity.

Conclusion
There is no denying that arbitrage funds are relatively less risky as compared to pure equities. However, to slot them as "risk-free", amounts to mis-representation. Arbitrage funds do have an element of risk; we have shown some of the scenarios wherein risk is imminent. Investors who are being told that arbitrage funds are less risky or are well placed to clock a definite return have been misled.

By the way, the reason why we have put 'risk-free' in quotes is that we picked this term from the presentation of a large fund house; they had used this term to describe their arbitrage fund.