Arbitrage funds: Returns likely to be healthy in rising or volatile markets

Excess funds chasing arbitrage opportunities may, however, reduce potential returns

Investors have been flocking to arbitrage funds in large numbers. Over the past three months ended February 29, 2024, this category has received net inflows of Rs 32,761.7 crore.

“With interest rates getting reset upward, arbitrage yields have moved higher. This increase was supported by continuing flows into equity markets and greater participation, which led to increased opportunities for arbitrage funds. A combination of reasonable returns, relatively low risk profile, and tax efficiency made these funds attractive to investors,” says Sirshendu Basu, head, products, Bandhan Asset Management Company (AMC).

How do they work

Arbitrage fund managers try to take advantage of the price differential between the cash and the futures segment. They do not take any directional risk in the equity market.

“An arbitrage fund is an equity-oriented hybrid fund which generates returns from the price differential between the equity and the derivative market of the same underlying stock. Since the position is completely hedged, the fund does not take any price risk,” says Sailesh Jain, fund manager, Tata Mutual Fund.

An arbitrage fund’s return is equal to the spread minus the scheme expense. A higher spread means higher gains on the transaction. “In a positive equity market environment, participation from foreign and domestic institutional investors and the retail category increases in the derivatives segment. The opportunity to invest at attractive yields improves for arbitrage funds. Hence, coupled with high interest rates, arbitrage funds have performed well in the past few months as compared to other short-duration debt funds,” says Sharwan Kumar Goyal, fund manager and head-passive, arbitrage and quant strategies, UTI AMC.

Drivers of returns

In the past year ended March 7, 2024, arbitrage funds (direct plans) have on average given a category average return of 8 per cent.

The returns of these funds are driven primarily by three key factors – money market yields, traders’ participation in the stock market, and the quantum of money chasing arbitrage opportunities.

At present, short-term rates are attractive. Open interest in the derivative market indicates high investor participation. If the markets continue to trend upward or remain volatile, these schemes should generate healthy returns.

“Arbitrage funds’ returns have been healthy since last year. The market continues to experience high volatility with large sector rotation during the past few months. Such volatility helps arbitrage funds generate higher returns,” says Jain.

If stocks trend downwards and the quantum of money chasing arbitrage opportunities keeps rising, their returns could decline. “Very few arbitrage opportunities may be available in a prolonged bear market. This can impact returns,” says Jain.

The tax attraction

A major reason for investors choosing arbitrage schemes is the equity taxation they enjoy. “An arbitrage fund holds a minimum 65 per cent of its investment in equity and equity-linked instruments, making it an equity scheme for taxation purposes,” says Jain.

Gains on units held for more than one year are taxed at 10 per cent if the gains exceed Rs 1 lakh in a financial year. Units held for less than one year are taxed at 15 per cent.

Debt funds have lost the indexation benefit since April 1, 2023. Gains booked on units of these funds acquired from this date have become taxable at slab rate.

Arbitrage funds also provide stability and liquidity. “They provide stable returns and a cushion during market downturns. They are open-ended, with a very short exit load period. Further, they invest in fairly liquid securities and are therefore very liquid in nature,” says Basu.

Who should invest?

Investors with moderate return expectations should invest in arbitrage funds. “The reasonable return expectation from arbitrage funds should be the interest rate around the shorter end of the yield curve,” says Goyal.

They are suitable for conservative investors. “Investors with a low risk appetite should opt for these funds. As in other market-linked instruments, there is no guarantee of profit. Those in the higher tax bracket, who wish to benefit from equity taxation, should also opt for them,” says Jain.

Investors must have a horizon of six to 12 months when investing in these funds.