Arbitrage funds: Making the best of stock market swings

Arbitrage funds, as a category, have been popular among investors for parking money temporarily in a tax-efficient manner. These funds, which are popular among corporates and high net-worth investors, typically make money by holding stocks and selling their futures. The gap between the two, called spread, gives the fund its returns.

“Although investing in a volatile market can be risky, arbitrage mutual funds work well in an unstable market and still offer lucrative returns. These funds capitalize on the market inefficiencies and generate profits for investors," said Priti Rathi Gupta, founder, LXME, a financial platform for women.

Arbitrage funds are conservative equity-oriented products, wherein the equity portion is fully hedged and the remaining part is primarily invested in high-quality debt instruments with lower maturities.

These funds invest at least 65% of their assets in stocks and a small part (around 20-30%) in debt, and this helps cushion returns. This essentially means that the level of risk that these funds carry is much lower.

However, this was not the case when this category turned negative last year. The arbitrage spread turned negative in March after many stock futures were traded at a deep discount on large selling by investors. This prompted some fund houses to stop taking fresh inflows in their arbitrage funds.

Things have improved since then. “Since last March, we have witnessed considerable improvement in the equity investor sentiment with lot of benchmark indices scaling new highs. In line with the same, the open interest in the stock futures have been rising steadily, leading to better opportunities or in other words improved spreads. As a result, the category delivered superior risk-adjusted returns," said Anand Gupta, fund manager, Nippon Life India Asset Management Ltd.

With the markets remaining volatile owing to the covid-19 pandemic and related factors, a lot of investors are now choosing to park their short-term money in arbitrage funds.

“Arbitrage returns usually reflect the near-term interest rates (bond yields) and in line with the lower interest rates or yields, the returns were comparatively lower, though it was relatively better compared with other alternatives," said Anand Gupta.

The returns given by these funds for the year got impacted by the base effect in the first half where returns were extremely low. With recovery in the market and higher open interest, returns improved over the past six months (over 100 basis points).

“Arbitrage funds typically provide a good opportunity for investments during volatile market conditions such as the one we are going through right now. This is because a larger number of arbitrage opportunities could become available, or arbitrage spreads could widen, thus offering investors a higher premium," said Kavitha Krishnan, senior analyst-manager research, Morningstar India.

Arbitrage funds are predominantly equity funds, but their returns are like liquid funds. In the past year, arbitrage funds on average delivered a return of 3.14% against more than 50% given by large-cap funds. So, what is driving demand for these funds?

“Though they are classified as equity funds, arbitrage funds offer a relatively lower risk-return profile, much like a debt fund. What this means is that these instruments are not linked to market movements. Instead, they are dependent on the arbitrage spreads," said Krishnan.

Despite offering a return profile much like that of a debt fund, these funds fall under the equity mutual funds category and are taxed as per the short-term capital gains tax rate of 15%. Debt funds on the other hand are taxed as per the investors’ tax slab and this can be more than 15%. After a year’s holding, gains in them above ₹1 lakh are taxed at 10%.

“Arbitrage funds are quite tax-efficient, and if you hold them for a year, they are taxed at par with equities. If someone has a large corpus and would like to park for a year or so, they can get good tax benefits in these funds. They can do well during volatile markets taking advantage of the high spreads. Observing the high valuations, stock markets can get a bit choppy going forward. This can be another reason why investors are venturing into these funds," said Rushabh Desai, a Mumbai-based mutual fund distributor.

For meeting short-term investment goals, mutual fund investors have the choice to invest in safe options such as ultra short-term funds and money market funds, which have delivered comparable returns to arbitrage funds from a one-year perspective.

“Over the past one year, ending May, money market funds and ultra-short funds, too, have generated returns in the range of 4%. However, arbitrage funds make more sense when investors park money for a period of 6-12 months compared with ultra-short term and liquid funds from a taxation perspective," said Krishnan.

Arbitrage funds are known to generate returns on par with liquid funds over the long term. However, arbitrage funds can be volatile over the very short term (one day or five weeks).

“Thus, investors should invest in these funds with a minimum investment time horizon of six to 12 months. If investors have less than six months, then liquid funds are the best. Arbitrage funds need to be looked in a different way. It is for investors who want to enjoy tax benefits; and arbitrage funds can be a really good alternative to ultra short term funds," said Desai.

Investors should note that these funds work based on the manager’s ability to capitalize on price differences, which essentially means that a manager could generate better returns when there are a higher number of arbitrage opportunities.

“Moreover, these funds have a comparatively higher expense ratio than debt funds due to the heavy reliance on the fund manager’s ability to use arbitrage opportunities to deliver profits," said LXME founder Gupta.

Even though arbitrage funds work best in fluctuating markets, a short-term period might not be sufficient for the instrument to perform.