5 things to note about arbitrage funds

By Niranjan Risbood |  12-08-14 | 

There seems to be a renewed interest in arbitrage funds. In fact, I recently read an article in the media advising investors to use such funds to park their short-term cash. Investors could do that, but they must remember that arbitrage funds are no substitutes for debt funds.

1)     To benefit, you have to time your exit

By definition, arbitrage is a financial transaction that has no risk, or rather minimal risk, associated with it. Equity funds that employ such a strategy strive to take advantage of the difference in prices of a security in the cash segment and the derivatives segment.

These funds simultaneously buy shares (cash segment) and sell futures (derivatives segment) of the same company as long as the futures are trading at a reasonable premium. On expiry, the cash and futures price coincide thus leading to positive returns for the investor. Such funds do not take a naked exposure to equities as each buy transaction in the cash market has a corresponding sell transaction in the futures market.

This is how a transaction would work.

At the start of August, Fund A buys Reliance shares for Rs 1,000/share and sells Reliance August futures at Rs 1,020.

Case I

Stock price at expiry = Rs 1,030

Cash segment = Gains of Rs 30 (1030-1000)

Futures exposure = Loss of Rs 10 (1020-1030)

Net gain = Rs 20

Case II

Stock price at expiry = Rs 980

Cash segment = Loss of Rs 20 (980-1000)

Futures exposure = Gain of Rs 40 (1020-980)

Net gain = Rs 20

The concept of arbitrage is based on the spot price and futures price of a stock coinciding on expiry of the futures contract. If you withdraw on a date other than the expiry date, there is a possibility of getting negative returns for that particular month. So it is preferable to exit from arbitrage funds immediately post expiry.

This is unlike an investment in an open-ended debt fund where you can redeem your investment at any point of time based on your liquidity requirement.

2)    It's not great for short-term money

If you have a short investment horizon, such a fund may not make sense. In fact, the possibility of earning returns lower than debt funds (we have assumed a return of 7% annualised as the benchmark) is high.

Ensure that you have a minimum holding period of at least six months going up preferably to a year. So to park your very short-term cash, you could still look at a debt fund.

In the table below, we looked at a 5-year period from August 2009 to July 2014. The returns less than a year are absolute, the 2-year return is annualised.

Monthly rolling returns

Returns 1 month 3 months 6 months 1 year 2 years
Minimum 0.10 0.50 1.40 3.87 5.91
Maximum 1.01 2.86 5.44 9.51 9.29
Average 0.62 1.85 3.83 7.99 8.18
Observations (returns<7% annualised) 43.3 31 21.8 18.4 21.6

Source: Morningstar Direct / Returns as of July 31, 2014 / All figures are in %

3)    All funds do not follow a pure arbitrage strategy

While most of the funds are pure arbitrage funds, some also have a mandate to invest a small portion of the portfolio in buybacks, open offers, delisting, takeover bids, mergers and IPOs. This could add to the volatility of returns from these funds. So do check with your financial adviser on this aspect before going ahead with the investment.

4)    These funds do not work well in all markets

Arbitrage funds do not work well in all markets. They stand out in volatile or buoyant markets, not range-bound ones or bear markets. The arbitrage strategy of buy stock - sell futures will not work if the futures price is trading at a discount to its spot price, which is common during a bearish phase.

Besides the market conditions being conducive to such funds, there are a limited number of stocks permitted to trade in the derivatives segment. The eligibility for a stock to trade in this segment depends upon the criteria laid down by the Securities and Exchange Board of India, or SEBI. So, by and large, there is a limited scope for scouting for opportunity.

This is the reason I am not so sure how long this category can sustain its upper hand. Returns from arbitrage funds depend on attractive arbitrage opportunities being available between the spot market and the futures market. Currently, an industry size of around Rs 5,000-6,000 crore can provide such arbitrage opportunities. If the assets under management in this segment increase, all this money will be chasing similar arbitrage opportunities and hence returns are likely to decline below its current average.

Average returns of debt funds & arbitrage funds

Category 3 months 6 months 1 year 2 years 3 years
Arbitrage 2.07 4.38 9.35 8.77 8.85
Ultrashort term 2.22 4.59 9.92 9.01 9.10
Short term 2.50 5.06 10.27 8.73 8.95
Intermediate bond 2.82 5.24 7.91 7.65 8.36

Source: Morningstar Direct / Returns as of July 31, 2014 / All figures are in %

5)    These funds are taxed favourably

An area where these funds stand apart is in the tax implication. Since arbitrage funds maintain an average exposure of more than 65% to equity, they are treated as equity funds. Which translates into no long-term capital gain tax if you hold it for more than a year, and no dividend distribution tax.

In the latest Union Budget, the government increased the long-term capital gains period on non-equity oriented funds from 12 months to 36 months and fixed the capital gains tax at 20% with indexation. So compared to debt funds, arbitrage funds do have a better tax angle. Moreover, a number of them distribute dividends, which is tax free and thus viewed favourably.

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Dec 29 2017 08:39 AM
It's an interesting and informative article. Need your guidance on one point. The short term capital gains on investment in Arbitrage Fund attracts 15% tax. Whereas if one opts for dividend option, it will be tax free. And there is no dividend distribution tax on Arbitrage Funds dividend distribution. So the returns would be same under growth option and under dividend option but with no tax on dividend income even if one exits the fund within 12 months. Is this correct?
Umesh Shah
98253 41356
Larissa Fernand
Aug 19 2014 08:25 AM
 Dear Chandra Singh,
Thank you for taking the time to post your feedback.
Niranjan would like to clarify that he did not write this article with the notion that arbitrage funds are bad investments. In fact, nowhere does he say it. He has just attempted to make investors aware of the various factors to consider while investing in arbitrage funds and not to blindly look at them as an alternative to debt funds.

The chances of an investor making better returns from the arbitrage strategy increases as the time of holding these funds increases as has been shown in the example.

Also, we wanted to bring investors’ attention to variations in name like “arbitrage plus” or “arbitrage advantage”. They must be made aware that there are funds which follow a slightly different strategy rather than that of pure arbitrage.

Finally, the arbitrage transaction by its very nature could lead to negative returns for a month in a volatile market where investors want to exit these investments in the middle of the month.

I do hope this clarifies your doubts.
Chandra Singh
Aug 18 2014 06:54 PM
 I am not convinced of some of these statements.
1.It is a favorable option even for 3 months - for example, IDFC arbitrage dividend yield option yields approx Rs.750 per month per lakh and that is tax free. That is superior to debt funds
2.They do well in bear markets also. They do not do well if there is very minimal fluctuation and there is predictable movement of the market - these situations are quite infrequent
3.Though all funds do not follow pure arbitrage strategy, it is spelt out in the name, if they are arbitrage or arbitrage advantage funds. So the investor has a choice between tax free status or better returns.
4.Timing the exit - the variation post expiry day is quite miniscule and I am not sure if one can capture the benefits from that by timing exit.
Please clarify if any of these are incorrect.
ramanathan dwarakanathan
Aug 14 2014 11:02 AM
 very timely one. www.ddramanathan.blogspot.in
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