Arbitrage schemes see uptick in flows as short-term investors play safe

Arbitrage schemes saw sharp uptick in flows in May as a spate of downgrades and payment delays by certain borrowers dented sentiments on shorter-duration schemes, which take credit risks in their portfolios.

“Typically, arbitrage schemes have lower exposure to credit papers and also tend to do well during volatile periods due to wider cash-futures spreads available,” said Kaustubh Belapurkar, director (fund research), Morningstar Investment.According to data from the Association of Mutual Funds in India, arbitrage schemes saw Rs 4,554 crore of inflows in May, which was three-times the inflows witnessed by the category in the previous month.

While election-related uncertainty is behind markets, analysts say there could be another bout of volatility.

“The broader markets have remained weak. So far, benchmarks have been resilient. However, if the US escalates the situation following India’s retaliatory trade tariffs, even the benchmarks could come under pressure. Meanwhile, the Street remains more concerned on the fallout of the US-China trade tensions,” said Deepak Jasani, head of retail research at HDFC Securities.

Arbitrage schemes typically generate returns by seeking opportunities in the price differences between the underlying stock and its “future” contracts. These price differences tend to be wider during volatile conditions. Data from Value Research shows that the arbitrage schemes’ one-year return stood at 5.8 per cent, which was slightly higher than the 5.7 per cent return given by the ultra-short category. The one-year returns of low duration schemes stood at 3 per cent.Industry players added investors in arbitrage schemes can see higher post-tax returns, if the different categories deliver similar performance.

“Arbitrage schemes are treated as equity funds, so if investments are realised within a year, they are liable to 15 per cent of short-term capital gains tax (STCG). If the investments are realised after a year, they are liable to long-term capital gains tax (LTCG) of 10 per cent,” said a senior industry official.In the case of a low duration and ultra-short schemes, the LTCG is only applicable on investments held for more than 36 months. “Even then, the LTCG in the case of these schemes is higher at 20 per cent as these are debt funds,” the official added.

The credit risks in duration schemes was under spotlight again as some of the low duration schemes had to bear steep markdown on their debt exposures to Dewan Housing Finance Corporation after the firm missed on its interest payment recently. The mark down led to 2-16 per cent fall in net asset values of the exposed low duration schemes, which led to sharp hit on investors’ returns.

Experts add that concerns over quality of credit exposures in some of the shorter duration schemes, have only increased since IL&FS crisis in September last year.

“Instances of rating downgrades and mark-to-market impact in some of the ultra short duration and low duration schemes, has made short-term investors look at arbitrage schemes as alternatives,” added Belapurkar.