What are arbitrage funds?
Arbitrage funds aim to capture the price difference between the spot price of a stock or index and its futures price when futures trade at a premium.
“In a typical arbitrage trade, the fund manager buys the stock in the spot market and sells its near-month futures contract at the higher futures price, thereby locking in the premium at the time of trade,” says Kaustubh Belapurkar, director – manager research, Morningstar Investment Research India. The strategy generates a near risk-free return.
Tax treatment makes them popular
Tax treatment has boosted their appeal. “Arbitrage funds qualify as equity funds for tax purposes because they maintain over 65 per cent gross equity exposure,” says Belapurkar. By contrast, debt mutual funds are taxed at the slab rate. “The downside risk is minimal, and the post-tax return can be meaningfully higher than that from bank fixed deposits or debt mutual funds,” says Nitin Agrawal, chief executive officer (CEO), Mutual Funds, InCred Money.
What caused the dip in inflows
One reason is a temporary compression in arbitrage spreads. “Compression in arbitrage spreads reduced price differentials between the cash and futures markets and made these strategies less rewarding,” says D P Singh, joint chief executive officer (CEO), SBI Mutual Fund.
Quarter-end and year-end cash management cycles by corporates also influence inflows into arbitrage funds. “Even minor tactical adjustments by large institutional and corporate investors can significantly impact inflows,” says Singh.
This year’s Union Budget hiked the securities transaction tax (STT) on derivatives, raising the cost of executing arbitrage trades. This is expected to have a small impact on the net returns of these funds.
Do arbitrage funds remain attractive?
Experts say the attractiveness of arbitrage funds depends on market conditions. “These funds are attractive when volatility supports healthy price differentials between the cash and futures markets,” says Singh. In such an environment, the post-tax returns of these funds compete well with liquid and money market funds.
Belapurkar is of the view that the decline in net inflows in February does not signal any structural change in the attractiveness of the category. “In a market such as India, arbitrage opportunities will continue to exist, which should keep these funds attractive,” he says.
When do they turn unattractive?
These funds can lose their appeal in certain market conditions. “They turn unattractive when declining market volatility narrows the spread between cash and futures markets and lowers yields,” says Singh. He adds that a prolonged period of low volatility can dampen performance. In such phases, several shorter-term debt categories can offer higher risk-adjusted, post-tax returns.
Excessive growth in category size also poses a risk. “Too much money chasing the same arbitrage trades could lead to arbitrage opportunities getting squeezed,” says Belapurkar. In his view, such a situation has not arisen yet.
Arbitrage funds suit investors in higher tax brackets who want a tax-efficient alternative to liquid, money market, and other shorter-duration debt funds. “Investors who wish to park their money for six to 12 months will find them attractive,” says Belapurkar.