Arbitrage funds give liquid-plus returns at low risk if held for long term

Retail investors, who have some liquidity which they don’t want to invest in the current volatile phase, may put it in arbitrage funds
One category that carries very low risk in ordinary circumstances but witnessed volatility and large outflows in March was arbitrage funds. According to industry sources, about Rs 32,000 crore flowed out of these funds (up to March 27). Experts say volatility has subsided. While there is no guarantee it won’t recur, the possibility of investors losing money in this category is low.

The primary reason for the pull-out of funds from this segment was that stock prices in the futures segment went into a discount, compared to the cash segment. Normally, the former trades at a premium to the latter. As a result, fund managers were unable to deploy profitably in arbitrage opportunities. Some like ICICI Prudential and Tata closed their funds to investments (for about 7-10 days in the third-fourth week of March). “If we had got substantial cash during that period, we would not have been able to deploy the money profitably,” says Rahul Singh, chief investment manager-equities, Tata Asset Management Company (AMC).

Explaining the cause of contraction in the spread, Singh says: “The spread contracted because of sentiment. Even Nifty futures were trading at a discount to cash. When sentiment is negative, and there is so much uncertainty around, what can happen over the next week or month tends to be more intensive in the futures segment than in cash.”

Spreads have normalised again, with futures trading at a premium to cash (this has to be so, as the price of futures has to reflect the carry cost). Both ICICI Prudential and Tata AMC have reopened their arbitrage funds for investment.  


Retail investors, who have some liquidity which they don’t want to invest in the current volatile phase, may put it in arbitrage funds. “Over the long term, you can expect arbitrage funds to give at least 50 basis points higher return than liquid funds. Even if returns are similar to liquid funds, investors will still enjoy better post-tax returns in these funds,” says Singh.

Prasunjit Mukherjee, chief executive officer of Plexus Management Services, explains that while short-term capital gains from liquid funds are taxed at the investor’s slab rate, an arbitrage fund is taxed at 15 per cent, which is advantageous to investors in a higher tax bracket.  If arbitrage funds are held for more than a year, the tax rate falls even lower to 10 per cent (for capital gains above Rs 1 lakh).

Volatility in these funds may have subsided for now. But what if it recurs? Experts say the chances of making a loss are extremely low in these funds. “The fund manager locks in the returns in these funds. They buy the stock and short the future when the latter is trading at a premium. Intra-month volatility can exist. But as long as the fund manager holds these instruments till the end of the month, he earns the expected returns,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisers India.

The key risk in this category, according to him, is that sometimes there are not enough opportunities to make these kinds of trades. “If the premium in the futures market is insignificant, compared to the spot market, returns can be lower in a particular month. But under normal market conditions, you can expect to make a reasonable return, equal to the cost of carry,” he says.

Investors may use these funds to earn liquid-plus returns at very low risk, with equity-like taxation. “In liquid funds, returns accrue with greater consistency. In arbitrage funds, there can be greater variation in month-on-month returns. But if you hold them for nine-12 months, you should do better,” says Belapurkar.

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