Ever since the change in taxation norms made debt funds less tax efficient for investment timeframes below three years, there's been a lot of buzz surrounding Arbitrage funds. Back then, Arbitrage funds were providing investors with returns close to or even exceeding 8.5 to 9 per cent per annum.
Over the past year, Arbitrage funds have performed considerably worse, with many of them performing at just about 7 per cent or less. Is this category of funds as hot as it used to be, and should you be investing into it?
How Arbitrage Funds workThe term 'Arbitrage' is used to describe an opportunity for earning a near zero risk profit, by cashing in on price discrepancies between markets. Arbitrage Mutual Funds exploit pricing differentials between the spot and futures markets, by performing something called 'cash and carry' arbitrage. For instance, let's say that Reliance Industries is trading at Rs. 1010 in the spot market, and its July Futures are trading at Rs 1015. The arbitrageur will then simultaneously buy Reliance Industries in the spot market and sell an equal quantity of Reliance Industries futures. On the expiry date, the spot and futures prices always coincide, leading to a riskless profit of Rs. 5, irrespective of the closing price. Try it for yourself by assuming any given closing price for Reliance Industries on the last Thursday of the month!
Are they good for the short term?Touted as a suitable and more tax efficient replacement for short term debt funds or even liquid funds, are Arbitrage funds really meant for parking short term money? According to a Morningstar study conducted a few years back, Arbitrage funds displayed a significant probability of earning sub-7 per cent annualized returns in short time frames ranging from 1-3 months. What this effectively means is that parking short term money in Arbitrage funds in the hope of achieving better post tax returns compared to debt funds may lead to lower returns that you may have earned from debt funds! It's recommended that you invest in Arbitrage funds with a minimum time horizon of six months, preferably going up to a year.
"The preferable holding period of arbitrage funds would be around 1 year. Not only from the risk-return perspective but also from the tax efficiency perspective also", says R. Raja, Head - Products, UTI AMC.
Check before you investMany Arbitrage funds are not really pure arbitrage funds, but their mandate actually permits them to invest in other instruments (for instance, buybacks, open offers, delisting, takeover bids, mergers or IPOs) up to certain ceiling limits. These funds usually have fancier names, with words 'plus' and 'blended' thrown in for good measure. For instance, IDFC Arbitrage Plus fund is permitted to take an exposure of up to 5 per cent in riskier assets. It's even allowed to function as a quasi-hybrid fund, going up to 35 per cent into assets such as "CBLO, Margin Fixed Deposits and in actively managed debt". The fund has grown at under 7 per cent per annum for the past two years, with many pure play debt funds providing double digit returns to investors in the same time frame.
"Completely hedged arbitrage funds on an average have given returns of around 6-6.5 per cent during the last one year", observes Raja.
The addition of these options to the so called plain vanilla mandate of investing into cash and carry arbitrage strategies may work to your detriment by increasing portfolio volatility, and may even create scenarios of suppressed returns. A careful check is in order, to ensure that you're not invested into a fund that doesn't match with your objectives.
The problem with cash and carry ArbitrageThe trouble with cash and carry Arbitrage is that 'you see what I see'! In other words, all the money invested into Arbitrage Funds will be chasing exactly the same Arbitrage opportunities. The scope for generating outperformance through tactical excellence doesn't really exist.
As more and more money flows into the Arbitrage position, the gap closes quickly and the opportunity evaporates. Experts estimate that there's enough scope to absorb between 5,000 Crores and 6,000 Crores of Arbitrage Fund money, while continuing to generate debt-beating post tax returns. The current industry AUM in this category stands at close to 29,000 Crores. This doesn't bode well for those seeking outperformance.
In addition to the above, Arbitrage Funds shine in bullish or volatile markets, but fail to stand out in bearish or range bound markets. The lack of Arbitrage opportunities may prompt the fund manager to sit in cash or short term debt instruments for extended periods of time. That really defeats your purpose of investing in these funds in any case.
Tax Efficiency - the silver liningSince Arbitrage Funds are technically a category of equity funds, their returns are tax free after a year and the profits earned before a year are taxed at 15 per cent (Short Term Capital Gains). This does give them an edge over debt funds.
"Arbitrage funds being equity funds have the same tax efficiency of equity funds. The long term capital gain, if the investment is held for more than one year is tax free at the hands of investor. The dividends distributed by the fund are totally tax exempt and the fund need not pay any dividend distribution tax", says Raja of UTI AMC.
The Final WordWhile Arbitrage Funds still warrant a place in the low risk portion of your portfolio, their more tax-inefficient cousins 'the debt funds' are catching up quickly. As Arbitrage opportunities reduce, so will the potential returns. Make sure you earmark 'one year plus' money for your Arbitrage funds in order to fully benefit from their tax efficiency vis a vis debt funds. For low risk capital that has a time horizon of over three years, opt for dynamic bond funds or longer term maturity debt funds instead.
Industry officials believe about Rs 3,000 crore may have moved out from arbitrage funds in the past three months. Who knows, this might be the shot in the arm that Arbitrage funds need? Only time will tell.
_20241003152432_original_image_28.webp)