Given the buoyancy in domestic equity markets, investors are moving out of arbitrage funds and investing in other hybrid categories or equity funds. The category witnessed net outflows for four months in a row till September. As the investment objective of arbitrage funds is more comparable with liquid funds for a slightly longer investment horizon, the latter have also seen net outflows in June, July and September this year.
Arbitrage funds invest about 65% of the portfolio in equities and the balance is invested in the money market or debt instruments. So, with the steepness of the yield curve, investors have tried to lock in higher yield by investing in target maturity funds and they have seen significant net inflows over the last few months. Arbitrage funds generally run fully-hedged equity positions. In other words, all their long equity / stock positions are hedged by selling the stock futures. They generate returns from the differential in the prices of stock futures and the underlying stock.
While arbitrage funds are ideal investment options for HNI investors, Anand Vardarajan, business head, Banking, Alternate Products & Product Strategy, Tata Asset Management, says that due to rate hikes, lately some other category funds like low duration category and money market have seen very good yields. While arbitrage fund returns have also moved up over the last six months, it is overshadowed by the returns of other peer categories.
Lagging in returns
Funds in other hybrid categories such as dynamic asset allocation, aggressive hybrid, equity savings hold a mix of unhedged equity positions, arbitrage and debt based on their mandate and market views. Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says due to higher allocations to unhedged equity positions other hybrid fund categories have out-performed arbitrage funds in recent times when domestic equity markets have recovered from the lows witnessed earlier this year and remain buoyant.
While typically, the arbitrage fund returns tend to be closer to repo rate over a 3-month or longer time horizon, the returns are derived from arbitrage in the equity markets. Roopali Prabhu, CIO and co-head, Products & Solutions, Sanctum Wealth, says roll spreads remained within a range whereas short term interest rates moved up in the past few months. “This explains the lag in returns relative to the liquid category. But the tax advantage provided by arbitrage funds leads to higher post-tax returns for arbitrage funds for individuals. With the current roll spreads turning attractive, the category has the potential to deliver comparable returns even on a pre-tax basis for the next six months or so,” she says.
Indian equities have outperformed major developed and developing markets over the past six to 12 months resulting in rich valuations versus other markets. “Investors holding this view can reduce allocations and go underweight to the tune of 2-4% to equity funds and park money in arbitrage funds given their market neutral positioning and tax advantage as compared with liquid funds. In case of sharp market falls, they can move back to equity,” says Kapadia.
Arbitrage funds take very low risk relative to other hybrid funds. As a result, volatility is low and return potential is also lower. Also, market volatility as seen in other equity funds is not witnessed in arbitrage funds. “We believe arbitrage funds continue to be an attractive category for investors with a three- to six-month investment horizon relative to comparable fixed income options, on a post-tax basis,” says Prabhu.
From a taxation perspective, arbitrage funds are classified as equity funds and are subject to equity mutual fund taxation. Given these characteristics, arbitrage funds are typically used for short term parking of funds given their tax advantage over debt funds particularly liquid and ultra-short term categories which are otherwise considered for short term parking purposes.