These hybrid funds generate returns by simultaneously buying equities and selling futures in the derivatives market. “These funds try to capture the price differential between the two markets,” says Harsha Upadhyaya, chief investment officer, Kotak Mahindra Asset Management Company.
Futures generally trade at a premium due to the cost of carry. A part of the portfolio of these funds is parked in high-quality fixed-income instruments for accrual income.
In bullish markets, arbitrage spreads widen. “The heightened demand for long futures positions leads to an increase in futures prices relative to spot prices. The widening spreads help arbitrage funds generate higher returns,” says Bhavesh Jain, co-head – factor investing, Edelweiss Mutual Fund.
In bearish phases, participants reduce long exposure and even initiate short positions. “The reduced demand for long futures causes arbitrage spreads to compress, which tends to lead to a decline in the returns of these funds,” says Jain.
In volatile markets, while spreads may narrow, price movements create opportunities. “Even with tighter spreads, the higher frequency of trades can help improve returns,” says Jain.
Past outperformance is a key factor. “The category’s strong 1–3-year performance compared to other short-term debt options has driven inflows in recent months,” says Upadhyaya.
Falling yields of shorter-duration funds due to the Reserve Bank of India’s rate cuts have also driven investors to these funds.
Arbitrage funds’ pre-tax returns are comparable to those of liquid funds. But the post-tax difference in returns is significant, particularly for investors in higher tax brackets. “Arbitrage funds are classified as equity-oriented and taxed at 20 per cent (short-term) and 12.5 per cent (long-term), compared to marginal income tax rates for debt funds,” says Prashant Raghunath Pimple, chief investment officer – fixed income, Baroda BNP Paribas Mutual Fund. The popularity of these funds surged especially after debt funds lost the indexation benefit.
Their low-risk and tax-efficient nature has contributed to the popularity of these funds.
These funds are not completely risk-free. “The portfolio value is subject to potential volatility due to daily movement of prices in the cash and futures markets,” says Pimple. This can lead to fluctuations in net asset values over the short term.
Returns, however, tend to stabilise over a monthly expiry cycle. “The probability of arbitrage funds delivering negative returns for investment horizons of more than a month is quite low,” says Pimple.
Conservative investors seeking equity-like tax benefits with low risk may go for them. “They suit investors with idle short-term money who want better post-tax returns than liquid or ultra-short duration debt funds,” says Rajani Tandale, senior vice-president, mutual fund, 1 Finance.
Risk-averse investors in the higher tax brackets may opt for them. “Systematic withdrawal plan users who want minimal volatility may also go for these funds,” says Tandale. She adds that these funds are not suitable for those who wish to park funds for less than one month. Investors may use them to replace a part of their liquid fund allocation.
Tandale suggests having a horizon of a minimum of three months, and six months or more ideally, to offset exit load and account for possible spread fluctuations. Exit loads of 0.25–0.5 per cent usually apply to redemptions within 30–90 days.
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