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Should you park your money in Arbitrage Funds?

They are equity-oriented funds that capitalise on price differences that exist between the cash and derivative market for a share. As the name suggest, the fund manager resorts to arbitrage strategies to make money.

Whenever there is market volatility, you often get to hear about this category of funds – arbitrage funds. Do you need to invest in it?

Let’s understand these arbitrage funds.

They are equity-oriented funds that capitalise on price differences that exist between the cash and derivative market for a share. As the name suggests, the fund manager resorts to arbitrage strategies to make money. 

Some consider it relatively safer than a regular equity fund since simultaneous positions are taken in the cash as well as the futures market for a stock that drastically reduces risk.

Supposedly safe trading

Suppose the price of a stock ‘A’ is Rs 100 in the cash market, while the price of its one-month futures contract is quoting at Rs 102. In this case, fund manager will buy the share ‘A’ in the cash market and sell it in the futures at Rs 102. On the day of settlement (after a month that is), price in the cash and futures market will converge. 

Let’s say the price on the day of settlement is Rs 103. In this case, the fund makes a profit of Rs 3 (Rs 103-100) from its ‘buy’ position in the cash market. However, it also makes a loss of Re.1 (Rs 102-103) since the future contract was sold at a lower price of Rs 102. In all, the fund pockets Rs 2 (3-1) from the entire arbitrage process. 

Over the years, arbitrage funds have not been able to offer a significant advantage over returns of liquid funds. In the last three years, arbitrage funds, gave annualised return of 5.8 percent, which was lesser than that of a liquid and ultra-short- duration fund. Its higher annual expense ratio (1.02%) as against that of liquid funds (0.30%) is a dampener to overall returns. 

No returns kicker


Returns of an arbitrage fund depend a lot on equity market volatility. A flat market, for instance, will result in a gain only at the end of the month, as in the above example. However, if there is market buoyancy or volatility, the opportunity to profit might arrive in a shorter time frame. Moreover, the fund manager needs to trade at frequent intervals in order to make a decent NAV gain. 

Over the years, arbitrage funds have not been able to offer a significant advantage over returns of liquid funds. In the last three years, arbitrage funds, gave annualised return of 5.8 percent, which was lesser than that of a liquid and ultra-short- duration fund. Its higher annual expense ratio (1.02%) as against that of liquid funds (0.30%) is a dampener to overall returns. 

Tax friendly

Since these funds invest at least 65 percent of their portfolio into equities, it enjoys lower capital gains taxes as an equity-oriented fund. 

A debt fund, if sold within three years, attracts short-term capital-gains tax (rate as per the investor’s income-tax slab). In contrast, arbitrage funds held for more than a year attracts long-term capital gains tax at 10 percent. And if sold within a year, short-term capital gains tax at 15 percent is applicable. 

While post-tax returns of arbitrage funds might be better than that of liquid or ultra-short duration funds, there are certain caveats.

Unpredictable payoff

Arbitrage fund makes money on sharp market movements. And trends in movement of India VIX – a measure of expected one-month volatility in Nifty – suggest such opportunities have been hard to come. In the last five years, value of VIX was more than 20 (a volatile market scenario) only seven percent of the times. Higher the VIX, higher is the expected volatility. 


Moreover, NAV of arbitrage funds are marked-to-market on a daily basis and its investors might incur losses on exiting before the expiry of a futures contract. Liquid funds, in contrast, are marked-to-market only if debt papers have a maturity of more than 30 days. 

Investors who temporarily park their funds need safety of capital at all times (more than returns). And that’s where liquid or ultra-short duration funds score over arbitrage funds along with its better risk-adjusted return profile (or superior Sharpe ratios). 

Takeaway

Arbitrage funds have underperformed liquid and ultra-short duration funds across time horizons. While it might score on the tax aspect, conservative investors are better-off parking their money in the tried-and-tested liquid or ultra-short duration funds. By doing that they are more assured of capital protection, while earning predictable returns from their investments. 

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