Arbitrage funds regain popularity among investors in mutual funds

Arbitrage funds see renewed interest as investors find attractive spreads and improved market sentiment, particularly among high-net-worth individuals. These funds provide moderate risk with the potential for high returns and are favoured for their tax efficiency over liquid funds.

Arbitrage funds have experienced increased inflows driven by market volatility and favourable post-tax returns relative to liquid funds. These funds typically allocate at least 65% of their assets to equities and the remaining 35% to debt and cash instruments.

Arbitrage funds employ a strategy where the fund manager buys shares in the cash market and sells them in futures or derivatives markets, profiting from the price difference. The current spread stands at approximately 63 basis points (bps), higher than the 40 bps observed in June last year. This increased spread contributes to the returns earned by investors in these funds.

These funds operate by taking advantage of the price disparity between stocks and their corresponding futures contracts, referred to as the arbitrage spread. During periods of market volatility, this spread tends to be significant, allowing arbitrage funds to generate attractive returns even in a lacklustre market environment. 

This consistent return potential with lower volatility has led to a notable inflow of Rs 3,700 crore in April, making it the highest among hybrid category funds. Sonam Srivastava, founder of Wright Research, an investment advisory firm, highlights the appeal of these funds in delivering high returns.

Investors seeking short-term investments favour Arbitrage funds that offer returns similar to liquid funds but with the tax implications of equity. Harshad Chetanwala, the co-founder of MyWealthGrowth.com, suggests that investors witnessing a surge in the stock market may prefer a cautious approach and opt to allocate their funds gradually. As a result, they may choose to park their investments in arbitrage funds for the time being.

Arbitrage funds typically maintain fully-hedged equity positions, meaning their long equity or stock positions are offset by selling stock futures. They generate profits by capitalising on the price difference between stock futures and the underlying stocks. In contrast, other hybrid funds categories like dynamic asset allocation, aggressive hybrid, and equity savings funds hold a combination of unhedged equity positions, arbitrage opportunities, and debt securities based on their investment mandate and market outlook.

With the recent amendments to the Finance Bill, 2023, arbitrage funds have become more tax efficient than liquid funds. As arbitrage funds allocate a minimum of 65% to equities, they are classified as equity funds. Short-term gains from arbitrage funds are taxed 15% if redeemed within one year, while long-term gains are taxed at 10% if redeemed after one year. On the other hand, liquid funds, classified as debt funds, are subject to taxation at the investor’s marginal rate for all gains. This makes arbitrage funds a more tax-efficient option. According to Hardik Gandhi, the chief business officer at Turtle Wealth, arbitrage funds outperform liquid funds regarding tax efficiency.

Abhishek Dev, CEO and co-founder of Epsilon Money Mart highlights that debt funds may not be as attractive for investors in the highest tax bracket due to the taxation of gains at the investor’s marginal rate. However, he emphasises that while tax considerations are important, choosing a financial product solely based on tax implications may not be the ideal approach. Investors should prioritise understanding the product they are investing in before making decisions.

Investors should consider the following factors when investing in arbitrage funds:

1. Arbitrage Opportunities: Returns from arbitrage funds depend on the availability of arbitrage opportunities in the market. Higher returns are typically seen during periods of high market volatility.
2. Investment Horizon: It is recommended to have an investment horizon of six months to one year when investing in arbitrage funds, as they can effectively navigate different market phases.
3. Risk and Return Potential: Arbitrage funds have lower risk than other hybrid funds, resulting in lower volatility. However, this also means that the return potential is relatively lower.
4. Different from Equity Funds: Unlike equity funds, arbitrage funds do not experience the same level of market volatility. Investors should be aware of this distinction when considering their investment options.
5. Debt Fund Considerations: Arbitrage funds can be viewed as an alternative to debt funds, particularly liquid funds, but investors should also consider that the interest rate cycle may have peaked. This suggests that returns from debt funds may rise in the future.

Investors should evaluate their risk tolerance, investment goals, and market conditions before deciding on allocating their funds.

For any clarifications/feedback on the topic, please contact the writer at samiksha.swayambhu@clear.in