Attractive spreads drive arbitrage funds to better returns in 2023

Staged strong comeback last year, stole march over debt funds to post best performance in 8 years

Arbitrage funds made a strong comeback in 2023 as a sharp improvement in performance along with a higher tax arbitrage vis-a-vis debt funds boosted investor interest in the low-risk hybrid offering.

The category has delivered 7.6 per cent return on an average in 2023, the highest since 2015.

The returns had ranged between 4.1 per cent and 4.6 per cent in the previous three calendar years, shows data from Value Research.

Experts say the surge in returns is a result of the widening of price differential between cash and the derivatives market.

“Arbitrage funds delivered encouraging returns on account of systemic interest rates edging higher and equity market buoyancy (as the cost of carry increases sharply) aiding performance,” said Chintan Haria, principal — investment strategy, ICICI Prudential AMC.
 

The fact that the government raised taxes on debt fund returns in April has also helped arbitrage funds garner higher flows.

Though arbitrage funds operate in the equity market, they compete with debt funds for flows. The returns are generally similar to a shorter-horizon debt fund.  
 

However, in 2023, arbitrage funds have outperformed almost all debt funds, except for the high-risk debt offering, credit risk funds.

Only floater funds have matched arbitrage funds in returns. On a post-tax basis, the differential in returns is even higher.

Arbitrage funds are treated as equity funds wherein the investor can avail long-term capital gains taxation rate of 10 per cent if the fund is held for one year or more. Short-term capital gains are taxed at 15 per cent.

Debt fund returns are taxed at the investors' slab rate irrespective of the investment duration, which can be as high as 30 per cent. This has led to higher inflows into arbitrage funds, especially from high net worth individuals (HNIs), said MF officials and advisors.
 

“Arbitrage funds have seen higher acceptance from corporates and HNI customers in recent years on the back of better tax-adjusted returns. They offer gross returns similar to liquid funds, but better on a tax-adjusted basis. The longer-term returns have been reasonably stable, helping overcome the perceived higher volatility of being an equity offering,” said Neeraj Kumar, Fund Manager, SBI Arbitrage Opportunities Fund.
 

Arbitrage funds have raked in Rs 48,300 crore in 2023 (January to November) with monthly flows topping Rs 5,000 crore every month since July.

The aggregate assets under management (AUMs) of the category jumped 65 per cent to Rs 1.2 trillion in November 2023 from Rs 74,722 crore at the end of 2022. In 2022, the AUM had declined 25 per cent, whereas in 2021 it had surged 62 per cent.

However, experts say that present arbitrage fund returns are not sustainable and investors should come in with lower expectations.

“The returns seen in 2023 are not sustainable. Investors should come with expectations of 4-5 per cent return, which is the longer-term average. At these levels, the post-tax returns are similar to that of shorter-horizon debt funds,” said Suresh Sadagopan, managing director (MD) & principal officer at Ladder7 Wealth Planners.
 

Arbitrage fund seeks to generate returns on the price differential in the cash and futures market.

In such a scheme, the fund manager simultaneously buys a company in the cash market and sells an equivalent quantity in the futures segment as long as the futures trade at a reasonable premium. The spread between the two generates the return for the scheme. A minimum of 65 per cent of the portfolio is deployed in this strategy. The rest is invested in debt instruments.