Arbitrage Funds gain traction

By Ravi Samalad |  18-05-21 | 
 
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About the Author
Ravi Samalad is Assistant Manager - Editoral for Morningstar.in.

After seeing net outflows to the tune of Rs 7,378 crore during July 2020 till December 2020, Arbitrage Funds have received cumulative net inflows worth Rs 20,601 crore since the last four months.

“Allocation came back as savings increased for retail investors for lack of spending. Corporates tightened their working capital, had higher profitability and deferred capital expenses due to which money flowed in most categories of funds,” says Nilesh Shah, Managing Director, Kotak Mutual Fund.

Over one year period as on May 17, 2021, the top performer - Tata Arbitrage has delivered 4.46% while the bottom performer Navi Arbitrage has delivered 0.43%. Over a 1,3 and 5-year period as on May 17, 2021, Arbitrage category has outperformed Liquid Fund category.

     

How do they work                                                                                        

Arbitrage Funds generate returns by exploiting mispriced opportunities between spot and futures prices in cash and derivative markets. Arbitrage opportunities can exist in the same stock between different exchanges or between a security and its futures price.

Suppose stock A is trading at Rs 50 on BSE and Rs 51 on NSE, the fund manager would simultaneously buy it on BSE and sell it on NSE at Rs 51, making a profit of Rs 1. Similarly, the fund manager can buy a stock at a spot price of Rs 100 in the cash market and simultaneously sell it at Rs 102 in the futures market, locking in a profit of Rs 2 over the duration of the contract. On the date of expiry, if the price differential between the spot and futures position of the subsequent month maturity still exists, fund managers rollover the futures position and hold onto the position in the spot market. By buying in the cash market and selling in the F&O market, fund managers lock-in profits irrespective of the price movement of the security.

In some instances, fund managers may unwind both the spot and the future position before the expiry of the current-month future for generating higher returns or to meet redemptions.

Arbitrage opportunities are more lucrative during volatile markets. Arbitrage opportunities can also exist during a bull market as future prices tend to be high which creates an opportunity to buy in the cash market and sell in the futures market. "Due to the COVID situation, there is a lot of volatility in the market which usually suits the arbitrage environment as you get to churn your portfolio regularly and do not need to wait till the expiry end for just rolling it over. Low interest rates, good arbitrage spreads and tax benefit make this category attractive," says Jignesh Rao, Fund Manager, Mirae Asset Mutual Fund.

The returns of arbitrage funds depend on the cost of carry (interest cost) and the mispricing opportunities. Since the transactions are fully hedged, these funds carry low risk.

Since these funds invest a minimum of 65% in equity and equity derivatives (remaining in debt), they are taxed as equity funds. When arbitrage opportunities are available, they can increase the exposure to arbitrage positions to 90% and reduce it to 65% when such opportunities diminish. Some Arbitrage Funds also invest in Liquid and Money Market Funds in the debt portion of the portfolio.

Exit Load

Arbitrage Funds levy exit load which is usually around 0.25% if the money is redeemed before 30 days (differs across funds). There is no exit load after 30 days.

Total Expense Ratio

Depending on the scheme assets under management, these funds can charge anywhere between 0.20% to 1% under direct plans. Regular plans can charge anywhere between 0.80% to 2%.

Should you invest?

Short term capital gains from Arbitrage Funds are taxed at 15% (excluding cess and surcharge) while long term capital gains up to Rs 1 lakh are tax-free if sold after one year. On the other hand, debt fund investors have to pay marginal tax rate (assuming 30% in highest tax bracket) for short term capital gains. “Many investors invest in Arbitrage Funds mainly because of its tax advantage over debt funds. However, I usually recommend Arbitrage Funds as a debt part of the client’s long term goals. They are not an alternative to Liquid Fund or Short Term Funds and must not be used for short term goals. It should be used as part of debt allocation, where we can use tax-free withdrawal (up to Rs 1 lakh) for rebalancing the portfolio,” says Bengaluru-based Registered Investment Adviser (RIA) Basavaraj Tonagatti.

Mumbai-based RIA Kavitha Menon says that Arbitrage Funds are not ideal for parking short term corpus due to the volatility of returns even if the risk is low. “I haven’t recommended Arbitrage Funds for two reasons. The returns are not linear and can fluctuate. Hence, it is not ideal for parking short term money. In a rising interest rate scenario, Short Term Funds will perform relatively better. The tax benefit is delusional. Post tax returns of Arbitrage Funds and Low Duration is more or less the same. Yet, the risk ratios of Arbitrage Funds are way higher than Short Term Debt.”

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