The reason why arbitrage funds are going up and up | Mint

The reason why arbitrage funds are going up and up



As the size of these funds go up, it will be difficult for them to find higher number of opportunities for arbitrage

Arbitrage funds had seen a record net inflow of 14,924 crore in July. This is the highest monthly net inflows received by the category of funds at least since April 2018. The inflows in these funds have been robust in calendar year 2021 as they have received a net inflow of 49,106 crore, while last year during the same period, arbitrage funds saw a net outflow of 15,248 crore. So, what is driving investors to these funds now?

There are a couple of factors that are resulting in strong inflows in these funds.

One could be that some of the high-net-worth individuals (HNIs) are using these funds to park the gains booked from equity markets. “I am broadly seeing a lot of HNIs parking their gains from equity markets as they look extremely expensive," said Kirtan Shah, co-founder and chief executive officer, SRE Wealth.

However, the net equity inflows in July were also at a record high, which clearly indicates that the trend is not widespread.

The other reason is the better tax-adjusted returns delivered by arbitrage funds when compared with liquid funds. Liquid funds have delivered returns of 3.13%, while arbitrage funds have delivered a slightly higher returns of 3.66% over the past one year, according to data available on

Photograph From Istock; Graphic By Paras Jain/Mint
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Photograph From Istock; Graphic By Paras Jain/Mint

Arbitrage funds are considered as an alternative to liquid funds. “In the past few months, arbitrage funds have delivered better linear post-tax returns compared with liquid funds," said Sailesh Jain, fund manager, Tata Mutual Fund.

The differential in return may not be much, but it is the tax efficiency of arbitrage funds that gives them an edge over debt funds, including liquid funds.

Arbitrage funds get the tax treatment of equity funds. In the case of equity funds, short-term gains (for a holding period of less than one year) are taxed at the rate of 15%, while in case of debt funds, short-term gains (for a holding period of less than three years) are taxed according to the slab rate, which can go up to 30% for a person falling in the highest tax bracket.

While the long-term capital gain exceeding 1 lakh is taxed at 10% in the case of equity funds, it is taxed at the rate of 20% post indexation in the case of debt mutual funds.

So, tax efficiency and lower volatility make arbitrage funds a good alternative to liquid funds. But are these good for retail investors? Before we come to that, let’s first understand how these funds work and does it make sense for retail investors to park money in these funds.

How arbitrage funds work: In simple terms, these funds generate returns by capturing the difference in the price of the same stock in the cash (also known as spot market) and the futures (where participants buy and sell contracts for delivery on a future date) markets, or differential in price of the same stock listed on two exchanges, by buying and selling the stock simultaneously.

Such opportunities are higher when the markets are volatile as it can lead to a wider price difference (or spread) between the cash and futures market.

So, let us assume Maruti Suzuki is trading at 1,000 in the cash market, while in the futures market (where the delivery of stock has to be done on a future date) price of the stock is trading at 1,050. So, the fund manager will buy the security in the cash market and sell it in the future market. This 50 is the profit that an investor will earn. Because buy and sell transactions are happening simultaneously, there is no volatility associated in the returns. So, arbitrage funds are able to deliver returns with lesser volatility, and the risk is lower even when compared with most categories of debt funds that we saw taking a hit in the past due to default of companies on principal or interest repayment. Arbitrage funds don’t generally give negative returns, but if it happens, it will only be temporary and the same will be recovered on the expiry of a future contract. It may happen in case the premium on the future contract turns negative before the date of expiry.

However, the returns from these funds depend on the availability of arbitrage opportunities in the market. Also, as the size of these funds go up, it will be difficult for them to find more and more arbitrage opportunities; this may impact returns. In the past, we have seen some arbitrage funds stop subscriptions during volatile times.

A few funds in the category stopped taking fresh subscriptions last year. “During the bull phase, the spread (differential between spot and futures price) goes up, which helps arbitrage funds deliver better returns," said Jain.

These funds are considered an alternative to liquid funds, which are often used by the retail investors to park their emergency corpus. However, it will also depend on your time horizon. “Arbitrage funds are best if you are looking at an investment horizon of up to six months," said Shah.

However, if you are looking for a shorter period, like one month or so, do remember that some of the arbitrage funds also have exit loads.

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