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Arbitrage mutual funds — a type of hybrid equity-oriented fund — takes advantage of the price difference in stocks in the cash and futures market.
Hence, they are best-suited for low-risk investors, as they offer steady returns and carry zero risk of capital losses. As the positions are fully hedged, these funds are effectively risk-free. Moreover, they have the facility to invest a major portion of the portfolio in FDs, debt and money market instruments that offer a better return.
Tax tangle
Mutual funds in India mostly trade on cash future arbitrage in individual stocks with liquid future contracts. For instance, Reliance Industries trades at ₹919 in the spot or cash market, and its one-month future trades at ₹924 on the same day.
An arbitrage fund buys the stock in the cash market and immediately sells the one-month future, raking in the ‘spread’ of ₹5 or an effective return of 0.5 per cent return. The fund repeats such trades every month.
Aside from practically risk-free and steady returns, arbitrage funds had one more advantage until the recent Budget. They enjoyed tax breaks available for equity-oriented funds because over 65 per cent of their portfolio is invested in stocks. But the Budget has more or less taken away the sheen from these funds.
The re-introduction of long-term capital gains tax at 10 per cent on stocks and equity mutual funds (on gains over ₹1 lakh), if held for over one year, has now made it less tax-efficient.
Top and bottom performer
There are about 19 funds in the arbitrage funds category. While the broader indices, the Sensex and the Nifty, have declined by about 2.7 per cent to 3.8 per cent over last three months, arbitrage funds have given positive returns in the 0.98-1.85 per cent range. The average category return is around 1.7 per cent.
Kotak Equity Arbitrage fund is the best performer in this category, delivering 6.31 per cent over the last one year. The fund deploys about 58 per cent in arbitrage trades and the balance in FDs, debt and money market. It allocates about 16.8 per cent in mutual fund units, 13.7 per cent in CBLO and term deposits.
L&T Arbitrage Opportunities Fund and Reliance Arbitrage Advantage Fund have also given similar returns of 6.29 and 6.28 per cent, respectively, over the last one year.
Principal Arbitrage, IDFC Arbitrage Plus and JM Arbitrage Advantage are the bottom three funds with returns in the 5.2-5.5 per cent range. DSP BlackRock Arbitrage is the new fund launched this January.
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