What Are Arbitrage Funds and How Do They Work?

Arbitrage funds are a type of mutual fund that seeks to profit from price differences between markets or securities. They take advantage of short-term inefficiencies, aiming for low-risk returns regardless of market direction. These funds appeal to conservative investors looking for stability while still participating in equity markets.

Since arbitrage opportunities depend on pricing gaps, these funds rely on specific strategies and market conditions. Understanding how they operate helps investors assess their potential benefits and risks.

Types of Arbitrage Strategies

The success of these funds depends on their ability to exploit pricing inefficiencies using different investment techniques. Fund managers use various approaches to capture returns while controlling exposure to market fluctuations.

Merger Arbitrage

This strategy involves trading shares of companies involved in mergers or acquisitions. When a firm announces an acquisition, the target company’s stock price typically rises but often remains below the agreed purchase price due to uncertainty about deal completion. Arbitrageurs buy shares of the target company and, if the acquisition involves stock rather than cash, may short-sell the acquiring firm’s stock to hedge risk.

Success depends on assessing deal probability, regulatory approval, and financing conditions. If the transaction proceeds as planned, the target company’s stock price converges with the acquisition price, allowing arbitrageurs to profit. However, if the deal falls through due to antitrust concerns or financing issues, the target company’s stock may decline sharply, leading to losses. Investors must evaluate government intervention, shareholder approval, and competing bids to determine whether the spread justifies the risk.

Convertible Arbitrage

This strategy focuses on convertible bonds, which can be exchanged for a predetermined number of shares of the issuing company’s stock. Investors typically take a long position in the convertible bond while short-selling the underlying stock, aiming to capitalize on pricing discrepancies between the bond and the equity.

Implied volatility plays a key role, as higher stock price fluctuations can increase the bond’s value while the short stock position offsets downside risk. Interest rate changes also matter—higher rates can lower bond prices but may reduce the cost of short-selling equities. Managing these positions requires constant rebalancing to maintain an optimal hedge ratio.

Statistical Arbitrage

This technique uses quantitative models and algorithms to identify pricing inefficiencies across a large set of securities. By analyzing historical correlations and price movements, traders execute high-frequency trades to exploit short-term deviations from expected value.

Pairs trading is a common approach, where an investor takes a long position in an undervalued stock while short-selling an overvalued counterpart. Execution speed is crucial, as market inefficiencies often disappear quickly. Many funds use automated systems to execute trades based on predefined statistical relationships. Risk management is essential, as errors in model assumptions or unexpected market shifts can lead to losses. Traders continuously refine their algorithms to adapt to changing market conditions.

Fund Structure

Arbitrage funds are typically structured as open-ended mutual funds, allowing investors to buy and sell shares at the fund’s net asset value (NAV) on any trading day. This liquidity makes them accessible to retail and institutional investors seeking market-neutral strategies. Fund managers allocate capital across arbitrage opportunities while balancing long and short positions to reduce exposure to overall market movements.

These funds operate within a framework that includes risk controls and leverage limits. Regulatory bodies such as the Securities and Exchange Commission (SEC) in the U.S. or the Securities and Exchange Board of India (SEBI) impose guidelines on portfolio composition, leverage usage, and disclosure requirements. For example, funds registered under the Investment Company Act of 1940 must adhere to diversification rules and maintain liquidity levels.

The underlying assets in an arbitrage fund vary, including equities, derivatives, and fixed-income instruments. Many funds use futures and options contracts to hedge positions, ensuring profits come from pricing inefficiencies rather than broad market movements. Derivatives trading introduces margin requirements, which fund managers must monitor to avoid forced liquidations.

Fund expenses, including management fees, brokerage costs, and transaction charges, affect net returns. Since arbitrage strategies rely on capturing small price differentials, excessive costs can diminish profitability. To mitigate this, fund managers negotiate lower trading commissions and optimize trade execution through algorithmic trading platforms. Some funds also generate extra income by lending out shares to short sellers.

Accounting Methods

Accurate accounting is essential for arbitrage funds, as their profitability depends on capturing small price discrepancies across multiple trades. These transactions require precise record-keeping to track gains, losses, and cost basis calculations. Funds typically follow Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) in other jurisdictions.

Mark-to-market (MTM) accounting is commonly used to reflect the fair value of securities held within the fund. Under MTM, assets are revalued at their current market price at the end of each reporting period. This approach is particularly relevant for arbitrage funds given their frequent trading activity. Unrealized gains and losses are recognized in the income statement, impacting reported earnings even if positions remain open. In the U.S., the IRS requires certain funds trading futures contracts to adhere to Section 1256 of the tax code, which mandates MTM treatment and applies a 60/40 tax split—60% of gains taxed as long-term and 40% as short-term, regardless of holding period.

Cost allocation is another key factor, as arbitrage funds execute high-frequency trades across different markets. The specific identification method allows funds to track individual lots of securities, optimizing tax efficiency by selecting the most advantageous purchase price when calculating capital gains. Alternatively, the first-in, first-out (FIFO) method assumes that the earliest acquired securities are sold first, which can lead to higher taxable gains in rising markets. Properly maintaining cost basis records ensures compliance with regulatory requirements.

Tax Considerations

The tax treatment of arbitrage funds depends on their investment composition and jurisdiction. In the U.S., these funds are often structured as regulated investment companies (RICs) under the Internal Revenue Code’s Subchapter M, allowing them to avoid entity-level taxation by distributing at least 90% of their taxable income to shareholders.

Short-term capital gains, generated from positions held for one year or less, are taxed at the investor’s marginal income tax rate, which can be as high as 37% for top earners. Long-term gains, applicable to securities held beyond a year, benefit from lower rates of 0%, 15%, or 20%, depending on taxable income. Since many arbitrage funds generate short-term gains due to rapid turnover, investors may face higher tax liabilities. Some funds use tax management strategies like loss harvesting, where unrealized losses are realized to offset gains and reduce taxable income.

Fees and Expenses

The cost structure of arbitrage funds affects investor returns, as these funds rely on capturing small price inefficiencies that can be eroded by excessive fees. Management fees typically range from 0.5% to 1.5% of assets under management (AUM), compensating fund managers for research, trading execution, and risk management. Some funds also charge performance fees, often structured as a percentage of profits above a specified benchmark.

Beyond management and performance fees, trading costs accumulate due to the high turnover nature of arbitrage strategies. Brokerage commissions, bid-ask spreads, and exchange fees all contribute to transaction expenses. Funds using derivatives may also incur margin costs, which fluctuate based on interest rates and market volatility. Expense ratios provide a consolidated view of these costs, helping investors assess whether potential returns justify the fees. Some funds implement expense caps to keep costs competitive.

Reporting and Documentation

Regulatory compliance and investor transparency require arbitrage funds to maintain detailed reporting. Fund managers must provide periodic disclosures, including audited financial statements, portfolio holdings, and risk assessments. In the U.S., funds registered under the Investment Company Act of 1940 must file Form N-PORT with the SEC, detailing portfolio composition and liquidity metrics. Investors also receive prospectuses and annual reports outlining fund performance and strategy adjustments.

Tax reporting is another key component, as arbitrage funds generate various forms of taxable income. Investors receive Form 1099-DIV or Schedule K-1, depending on the fund structure, summarizing dividends, capital gains, and other distributions. Funds trading futures or options may also issue Form 1099-B, detailing gains and losses subject to special tax treatment. Institutional investors often require customized reports, including stress testing results and scenario analyses, to evaluate fund resilience under different market conditions.