Why arbitrage mutual funds are becoming attractive

Arbitrage mutual funds, which are considered an alternative to short-term investment options such as liquid and ultra-short-duration funds, have been attracting investors’ attention of late.

Data compiled from the Association of Mutual Funds in India show that assets under management (AUM) of arbitrage funds have surged about 22 per cent to ₹63,310 crore as on July 26, from ₹52,062 crore on March 31, 2019.

The surge may be attributed to the recent instances of credit downgrades and defaults impacting the sentiment towards some debt mutual funds, including liquid funds.

Arbitrage MFs try to capitalise on the price differential of the same asset (stock or index) between two markets such as cash and futures markets. The risk in these funds is therefore relatively lower, similar to liquid funds.

Change in tax structure

The tweak introduced in Budget 2014-15, which increased the holding period to qualify for long-term capital gains (LTCG) tax in debt funds from 12 months to 36 months, made liquid funds less attractive. On the other hand, the taxation in equity funds was left unchanged and they continued enjoying tax exemption on LTCG (if the units were sold after 12 months) and dividend declared.

Since arbitrage funds are treated as equity funds for taxation purposes, investors turned to these funds to park their short-term money after 2014. Also, investors seeking regular incomes parked their money in the dividend plans of arbitrage funds.

However, the introduction of 10 per cent tax on LTCG and the dividend declared by equity funds in Budget 2018-19 made many investors move away from arbitrage funds. The dividend plans of such funds witnessed a huge outflow after March 2018 (see graph).

But recent instances of default by some debt funds seem to have made investors turn to arbitrage funds once again.

Volatile returns

The returns generated by arbitrage funds depend on the volatility in the equity market and the prevailing short-term rates in the money market.

“When there is a bullish sentiment and an upward trending equity market, arbitrage funds typically give good returns,” said Anil Ghelani, Head of Passive Investments & Products, DSP Investment Managers. The returns are lower when there is a bearish sentiment in the equity market.

Anand Gupta, Fund Manager, Reliance Nippon Life Asset Management Ltd, said: “The spread (difference between the price in the cash market and futures market) is determined by the interest-rate levels in the system and the level of activity in the cash and futures market. If the interest rates are low, arbitrage spreads also will be low, and vice-versa.”

The recent performance of arbitrage funds has been noteworthy. Over the past year, they have delivered an annualised return of 7.5 per cent while liquid and overnight funds have generated 6.6 and 6 per cent, respectively.

Tax advantage

It is tax-efficiency that makes arbitrage funds a superior option to liquid and other short-term debt funds. Arbitrage funds are well-suited for investors in the 20 per cent or 30 per cent tax bracket looking for a safe six-months-to-one-year parking ground for their money. Reliance Arbitrage, DSP Arbitrage, IDFC Arbitrage and ICICI Pru Equity-Arbitrage are some of the top performing funds.

However, arbitrage funds can generate negative returns in the very short term. Our back-of-the-envelope calculation based on their NAVs over the past five years shows these funds generated negative returns for a holding period of up to 45 days.