2 min read.Updated: 22 Mar 2020, 01:02 PM ISTNeil Borate
Arbitrage funds, despite their debt-like returns, are treated as equity funds for tax purposes
Over the past year, average return of arbitrage funds had stood at 5.92%. Over the past week, this fell to -0.09%
Tata Mutual Fund, on 19 March, shuttered itself to fresh inflows in its Arbitrage Fund citing the need to protect investors from volatility. ICICI Prudential Mutual Fund followed suit on 20 March, refusing fresh inflows between 21st and 31st March. Broadly, notes put out by asset management companies (AMCs) said the moves were on account of a drastic fall in arbitrage opportunities in the market due to the overall selling pressure.
Arbitrage funds typically make money by holding stocks and selling their futures. The gap between the two, called spread, gives the fund its returns. This return is usually the same as the prevailing interest rate in the economy. Arbitrage funds, despite their debt-like returns, are treated as equity funds for tax purposes and are hence popular among High Net Worth Individuals (HNIs). At the end of February 2020, these funds had 85,360 crore worth of assets under management (AUM).
A note by ICICI Prudential AMC said arbitrage spreads had contracted due to heavy selling by Foreign Institutional Investors (FIIs) and hence it expects below average returns in its arbitrage funds. Under normal conditions, spreads are 0.3-0.4% but they have now fallen to 0.15-0.20% and many securities have their futures trading at a discount. Instead, ICICI Prudential AMC directed investors to its Ultra Short, Savings and Money Market Funds if they have a horizon of less than 3 months due to an increase in yields by 0.4-0.8% across the curve (meaning across different maturities of bonds).
"Investors should avoid arbitrage funds for the next month. There will also be some impact on the returns of other funds using arbitrage like Balanced Advantage and Equity Savings. However, existing investors in these schemes will not suffer since arbitrage would have already been locked in for them by the schemes," said Viral Bhatt, a Mumbai based mutual fund distributor.
Kaustubh Belapurkar, Director, Fund Research at Morningstar Investment Advisor, India, differentiated between the two hybrid categories in terms of impact. "The spread contraction will have some impact on equity savings funds since they have roughly a third of their assets in arbitrage strategies. For Balanced Advantage Funds, there will not be much impact," he said.
A note from Edelweiss Mutual Fund argued against exiting arbitrage funds. "The current discount in futures is unlikely to continue in the coming weeks and there is no reason for investors to switch out of arbitrage funds and move into other avenues for a couple of weeks and then reinvest in arbitrage funds. This may not be a prudent strategy in view of the tax implications, ensuing volatility in debt markets and opportunity loss in case of potential rise in arbitrage spreads in coming days," it said.
Over the past year, average return of arbitrage funds had stood at 5.92%. However over the past week, this fell to -0.09%, as the Nifty index declined around 12%. Investors should be wary about entering this category while volatility persists.