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Home / Money / Personal Finance /  Should you invest in arbitrage funds?

Investors with a time horizon of up to one year, typically, invest in short-term debt mutual funds or bank fixed deposits for predictable returns with negligible risk of losing the capital invested. However, the freeze in six debt schemes of Franklin Templeton Mutual Fund, including its ultra short-term bond fund, has brought home the issue of credit risk in short-term debt funds. While picking a well-managed conservative debt fund is one solution to this problem, investing in arbitrage funds that combine the benefits of reasonable predictability of returns with low risk and better post-tax returns could be an option to consider, especially if you are in the highest tax bracket.

Arbitrage funds create positions in the equity spot and futures markets to exploit arbitrage opportunities that arise due to mis-pricing in these markets. Funds buy a stock in the lower-priced spot market and sell it in the higher-priced futures market. The difference in the prices between the two markets is the fund’s return, irrespective of subsequent price movements. Say, a stock trades at 100 in the spot market and the near-month (one month) future trades at 102. On settlement day, the price in the cash and futures market will converge. Let’s say, the price is 103 and both positions are unwound at this price. In the cash market, the investor makes a profit of 3 but in the derivatives market, the investor makes a loss of 1 since the future was sold at 102. The total profit from this transaction then is 2. This is the price differential at which the trade was originally set up (102 - 100) and is locked-in, irrespective of the price at settlement being different than the price at the time of the transaction. The gains and losses in both the markets cancel each other out leaving the fund to earn the original price differential between the spot and futures market. This gives investors a return that is equal to the short-term interest rate in the economy (similar to what liquid funds get).

Arbitrage funds have delivered an average return of 5.68% over the past year and 5.75% over the past three years, according to data from Value Research as on 6 May. This is similar to 5.66% and 6.48% in liquid funds.

However, the equation changes when you consider tax. Since arbitrage funds invest in equity, they are taxed as equity (15% for holding periods less than one year and 10% for longer holding periods). This makes them more tax-efficient than debt funds in the very short term. This is because gains from debt funds held for less than three years are taxed at slab rates and at 20% with indexation, thereafter. For an investor in the 30% bracket, this will be a much higher rate than the 15% he would pay on an arbitrage fund. The post-tax return for him would be 5.11% in an arbitrage funds and just 3.96% in liquid funds, over the past year.

Should investors then consider arbitrage funds as an alternative to park short-term funds? From a post-tax return perspective, there is a case for arbitrage funds. Despite being in the equity category, returns from arbitrage funds are not influenced significantly by bull and bear markets. Instead their return simply follows the short-term interest rate in the economy. Volatile markets provide greater opportunities to exploit mis-pricing and outperform liquid funds.

But investors should be aware of the risks. Extreme conditions in equity markets can cause temporary disruptions. A sharp market correction in March resulted in futures for many stocks trading at a discount rather than a premium to their spot price. This ate into the returns of arbitrage funds and two asset management companies, ICICI Prudential Mutual Fund and Tata Mutual Fund, had to temporarily halt fresh inflows into their respective arbitrage funds. “Spot-future spreads do fluctuate according to bullishness or bearishness in the market. During bear markets, spreads can disappear or go negative, but arbitrage funds capture this volatility. We suggest at least a three-month investing horizon in this category," said Harsha Upadhyaya, chief investment officer, Kotak Asset Management Co. Since the spot and futures positions of arbitrage funds are marked to market, there are periods when net asset values (NAVs) fall. Investors should be willing to hold for minimum periods of three to six months to allow the positions to play out.

Also, a portion of arbitrage funds (20-35%) is invested in debt instruments and may carry credit risk. Typically, this portion is invested in low- risk bank debt or just bank FDs, but you should still check this.

“Investors with a time horizon of six months to three years and who are in the 30% tax bracket should consider arbitrage funds. But do not keep all your eggs in one basket. Also, keep a close watch on the debt portion of arbitrage fund of the corpus and its credit quality," said Nithin Sasikumar, co-founder, Investography.

Viral Bhatt, a Mumbai-based mutual fund distributor, has a narrower time frame. “Given the possible credit risks in debt funds in the current economic scenario, I think arbitrage funds are a good option for a 6-12-month time horizon. I do not recommend it for longer time periods because at that time horizon, other hybrid categories become competitive," he said.

Investors in the 30% tax bracket may consider allocating some part of their very short-term money to arbitrage funds. However, it is best if they have an adviser to understand the nuances of the risk and return strategy of the fund. Also, note that since arbitrage funds fall in the equity category, redemption takes four to five working days instead of one to two days in debt funds. Choose a large-sized fund, which is less vulnerable to sudden redemptions by institutional investors, which can affect returns in small funds of this nature.

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