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Arbitrage funds: less understood and under-purchased

It is a good time to invest in arbitrage funds for a 3-6-month investment horizon

Arbitrage in essence is an opportunity to benefit from price inefficiencies of a given security in two different markets, mostly between spot (current) market and derivatives (futures) market. In that sense, arbitrage funds are low-risk products as these don’t take any directional bet on equities and just lock in the spread available between the cash and futures markets.

Let’s take an example to understand this better. Say, a stock is trading at 100 in the cash market. and you buy it at this price today. However, today itself, the price of that stock in the futures market is 100.60, for transacting one month from now. Since the future price of the stock is at a premium to the spot price, you sell the stock in the futures market and lock an absolute yield of 0.60% (which translates into an annualized yield of 7.2%).

Arbitrage funds are treated as quasi liquid as they bear almost the same risk as liquid funds but benefit from more advantageous taxation rules. And yet the total assets under management (AUM) of arbitrage funds stands at just 22,000 crore as against that of liquid funds, which stands at around 3 lakh crore.

This lack of enthusiasm from investors may possibly be because they have little or no information about arbitrage funds and don’t understand its potential, especially when compared with other types of funds in the same category of investment horizon such as liquid funds.

These funds are taxed as equity funds and do not incur capital gains tax if held for more than 12 months. If held for a lesser period, returns from these are taxed at 15%, plus 3% cess and surcharge, as applicable. Apart from this, the dividend received is tax-free in the hands of investors.

The returns from an arbitrage fund are dependent on the spreads one can make between the cash and futures position. The spread, in turn, is dependent on factors such as the general sentiment towards equities, liquidity in the debt market, currency hedging cost and consequently, participation by foreign institutional investors (FIIs) in the futures and options segment.

The most critical of all these aspects is investor sentiment towards equities because positive sentiment leads to investors taking long positions in the futures market. This works in the favour of arbitrage funds because under such circumstances, investors are willing to pay a higher premium on their positions, thereby increasing the price spread and creating enough arbitrage opportunities, which such funds can then take advantage of.

Investment outlook

In my view, we are headed towards a bull run despite the volatility we are currently witnessing and are likely to witness in the interim. In the coming few months or quarters, corporate earnings are expected to pick up and we could also receive clarity on the implementation of certain key governmental reforms. This is likely to boost sentiments, which means that traders will be bullish on more stocks. Subsequently, the number of participants who will take long positions on stocks is likely to shoot up thereby increasing the trade volumes.

Therefore, it is a good time to invest in arbitrage funds for a 3-6-month investment horizon. However, investors looking at parking very short-term money—for a few weeks or a month—should give this category a miss. These funds can be volatile due to mark-to-market rule because the cash and futures markets converge only on the expiry day; the prices can be unstable until then. The monthly returns of arbitrage funds can also be volatile due to monthly expiry at different spreads, which gradually gets evened out as the time horizon increases.

Although this category has been outperforming the liquid fund category for some time now, this outperformance may not sustain in future. Nonetheless, currently, on a post-tax basis, the returns are expected to be better than liquid funds making the category an attractive option.

Feroze Azeez, deputy chief executive officer, Anand Rathi Private Wealth Management.

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