MUTUAL FUNDS: Arbitrage funds are back in favour

Given the attractive spreads and the improving sentiment in the equity market, arbitrage funds are gaining traction from investors, especially among high-networth individuals. These funds offer an opportunity for high returns with moderate risk and investors are preferring them given the tax efficiency compared to liquid funds.

Arbitrage funds have seen an uptick in inflows due to the market volatility and decent post-tax returns as compared to liquid funds. These funds invest a minimum of 65% of the corpus in equity and the balance 35% in debt and cash instruments.

In these funds, the fund manager simultaneously buys shares in the cash market and sells them in futures or derivatives markets and the difference in the cost price and selling price is the return that the investors earns. The current spread is around 63 basis points (bps) as compared with around 40 bps in June last year.

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Arbitrage mechanism

The mechanism of these funds revolves around exploiting the price difference between stocks and their corresponding futures contracts, known as the arbitrage spread. Sonam Srivastava, founder, Wright Research, an investment advisory firm, says this difference tends to be substantial in volatile markets, enabling arbitrage funds to deliver high returns even when the overall market is not performing well. “Their potential to generate consistent returns with lower volatility is likely why these funds have witnessed an inflow of Rs 3,700 crore in April, the highest in the hybrid category,” he adds.

Investors look at arbitrage funds for short-term investments where the returns are closer to liquid funds but the tax implications are of equity. Harshad Chetanwala, co-founder, MyWealthGrowth. com, says, there is a possibility that investors who are seeing the stock market surging at present would like to hold on with their investment decisions at present and prefer going gradually. “Hence, they could be parking such funds in arbitrage funds,” points out Chetanwala.

Arbitrage funds generally run fully-hedged equity positions. In other words, all their long equity / stock positions are hedged by selling the stock futures. They generate returns from the differential in the prices of stock futures and the underlying stock. Funds in other hybrid categories such as dynamic asset allocation, aggressive hybrid and equity savings hold a mix of unhedged equity positions, arbitrage and debt based on their mandate and market views.

Tax efficiency

After the amendments to the Finance Bill, 2023, arbitrage funds are turning out to be more tax efficient than liquid funds. As arbitrage funds maintain a minimum of 65% equity allocation, they are treated as equity funds. Short term gains are taxed 15% if redeemed within one year and 10% for long term if redeemed after one year. On the other hand, liquid funds are taxed as debt funds where all gains are taxed at the marginal rate of the investor. “Arbitrage funds are more tax efficient than liquid funds,” says Hardik Gandhi, chief business Officer, Turtle Wealth.

Similarly, Abhishek Dev, CEO and co-founder, Epsilon Money Mart, says if an investor falls in the highest tax bracket, debt funds can prove to be a tad unattractive when it comes to taxation as the gains are taxed at the investor’s marginal rate. “While tax is an important aspect of the overall financial planning, selecting a product based only on tax is not the right way. Therefore, investors should first understand what they are getting into.”

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What to keep in mind

Investors must keep in mind that returns from arbitrage funds will depend on the arbitrage opportunities. These funds give higher returns during periods of high market volatility. Individuals should look at an investment horizon of six months to one year to ride the different market phases. As these funds take very low risk relative to other hybrid funds, volatility is low and return potential is also lower. However, the market volatility as seen in other equity funds is not witnessed in arbitrage funds.

While investors consider arbitrage funds as an alternative to debt funds, especially liquid funds, they must also keep in mind the interest rate cycle has peaked and returns from debt funds are likely to rise now.