Investors are increasingly preferring arbitrage funds over liquid and ultra-short-term funds for parking their short-term capital to capitalise on the price differentials between cash and derivative markets. The tax structure is also making these funds attractive for individuals in the highest tax bracket.
On a pre-tax basis, arbitrage funds have delivered an average return of 7.1% in the last one year, outperforming liquid funds (6.7%). While the differences might seem modest on a pre-tax basis, the post-tax differentials are substantial, nearing 200 basis points, enhancing the attractiveness of arbitrage funds as an investment option.
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. Arbitrage funds are treated as equity funds wherein the investor can avail long term capital gains taxation rate of 10% if the fund is held for one year or more, while short term capital gains are taxed at 15%.
In contrast, debt fund investments made after March 31, 2023 are taxed at the slab rate irrespective of the holding period. In fact, arbitrage funds have witnessed substantial net inflows of `49,000 crore since April of this year, accounting for 68% of the total net inflows in hybrid funds.
Feroze Azeez, deputy CEO, Anand Rathi Wealth, says past returns of arbitrage funds have been high and the roll-over premium is still elevated and greater than liquid funds yields. “The returns for December are expected at 7.5-8% looking at the cost of carry in stock futures. The outlook is attractive till the arbitrage fund’s open interest in stock futures is lower than 40% of the total open interest in stock futures,” he says.
Nirav Karkera, head, Research, Fisdom, says the efficiency translates into improved after-tax returns, particularly benefiting investors in higher-income tax brackets. “The flexibility in tax planning, coupled with the relative tax efficiency compared to fixed-income instruments, makes arbitrage funds an attractive option for those seeking enhanced returns with a tax-efficient approach in the short to medium term,” he says.
Some caution
Arbitrage funds’ returns are a combination of prevailing interest rate as well as bullish view of long rollovers on the stock. Hitash Dang, dealer, Equity and co-fund manager, Equity, PGIM India Mutual Fund, says one concern may be the breadth of arbitrage opportunities available. “As there are only 184 stocks in futures and options segment, investors can only take long positions in futures of these stocks. We expect demand and rollovers of these stocks to be good.”
Arbitrage funds feature higher volatility as compared with liquid funds, but they serve investment needs having a slightly longer time horizon and appetite for such volatility. Investors should exercise caution when choosing between arbitrage and liquid funds as the interest rate cycle peaks. Arbitrage funds have the flexibility to participate in debt investments once they fulfil the mandated 65% equity investment which is fully hedged. This means that most arbitrage funds’ investment mandate offers the flexibility to maximise returns across interest rate cycles.
In uncertain market conditions, arbitrage strategies offer relatively lower risk and tax efficiency, making them appealing to those seeking stable returns with reduced volatility. Soumya Sarkar, co-founder, Wealth Redefine, says, while arbitrage funds may provide stable returns, rising interest rates can impact their performance and liquid funds could benefit from increasing rates. “Investors should assess their risk tolerance and investment goals to make an informed decision, considering the evolving economic conditions and potential impacts on fund returns.”
What to keep in mind
Before investing in arbitrage funds, investors should assess their risk tolerance and keep in mind that while these funds are generally low-risk, they are not risk-free. They should be mindful of current market conditions as arbitrage funds thrive on market volatility. “Understand the specific strategy employed by the fund, consider tax implications, and determine if the fund’s investment horizon aligns with your goals,” says Karkera.