Should you invest in arbitrage funds?

Arbitrage funds and liquid funds are both short-term investment options. With lower returns from liquid funds of late, arbitrage funds are coming into the spotlight.

While recent net inflows in to liquid funds have been volatile, it has been positive for arbitrage funds in the three consecutive months until March 2021. This could be due to the better performance of the latter in the recent past. In the last one-, three-, five-, six- and ten-month period, arbitrage funds delivered higher returns (on annualised basis) over liquid funds by 10-185 basis points.

Here, we look at some of the differences between arbitrage funds and liquid funds, suitability, and the factors one should consider before investing in arbitrage funds.

Aribtrage vs liquid funds

Arbitrage funds seek to generate returns from the mispricing opportunities that arise in equities between the cash and futures market. For example, profits arise by buying a stock at a cheaper price in cash market and selling the same at a higher price in the futures market. Though investing in the equity market, the directional risk (risk of rise or fall in market) is minimum since these funds take both long (buy) and short (sell) positions (and vice-versa) at the same time on the same asset.

Liquid funds invest in short-term debt and money market instruments such as treasury bills, government securities, repos, certificates of deposit, or commercial paper.

These low-risk liquid schemes are typical avenues where investors park emergency or idle cash

However, in the last one year, the performance of liquid funds has been on par with or slightly lower than the saving deposits interest rates. Compared to 6.4 per cent (2018) and 6.9 per cent (2019) return clocked by liquid funds, the category returns in 2020 and 2021 (year-to-date) have dimmed to 4.04 per cent and 3.2 per cent respectively.

Arbitrage funds, during the last one year, delivered about 3 per cent per annum while beating the liquid fund returns in the period lower than one year (see table).

Arbitrage funds, for taxation purpose, are considered as equity funds since they are required to hold at least 65 per cent in equities (including derivatives). The redemptions from these funds are taxed at 15 per cent for short-term capital gains tax for gains up to one year and 10 per cent for a longer holding period for gains above ₹1 lakh.

The units of liquid funds redeemed before 36 months from the date of allotment attract short-term capital gains tax and the returns are taxed at the income tax slab rates. And long-term capital gains tax at the rate of 20 per cent with indexation benefits.

Points to note

For arbitrage funds, bull market may be a good time to look for arbitrage opportunities — based on which arbitrage funds earn returns. In bullish markets, investors who are long on futures make money more often than not and, hence, are ready to pay a higher premium.

Secondly, returns of an arbitrage fund depend on the interest rates in the economy.

As the cost of carrying comes down, the futures trade at lower premiums, bringing down the arbitrage spreads, says Shanbhag, Head, Investment Products, Motilal Oswal Private Wealth Management. Thus, as the interest rates fall, returns from arbitrage funds decline.

Further, one should note that the returns could be inversely related to the industry size as more money chasing the same arbitrage opportunities leads to lower returns. As the asset size grows, the arbitrage exposure in the market increases and reduces premiums, which would impact returns of arbitrage funds.

Also, as these funds can invest up to 35 per cent of their corpus in debt segment, one needs to check the risk quotient of the debt instruments.

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