The appeal of arbitrage funds stems from the reasonably stable returns and their taxation as equity funds.

Arbitrage funds are receiving substantial inflows of late, which is good from an overall perspective, as it suggests a growing market. However, one needs to have the right understanding and expectation while getting into this category of funds. To put it simply, these are not substitutes for liquid funds. Sometimes, there is significant volatility in the corpus size of funds in this category, which is the context of making this comment. Volatility means movement on both sides – withdrawal due to concerns and inflows with certain expectations.

Heavy outflows during corrections

Let’s go back a bit in time. In March 2020, arbitrage funds as a category lost as much as Rs 33,800 crore of month-end AUM (assets under management) having come down to Rs 52,200 crore from Rs 85,400 crore as of end-February 2020. Thereafter, the category saw inflows from April to June 2020, but witnessed outflows in July 2020. What was the issue? In March 2020, due to certain typical market conditions, the spread (i.e., the difference between the price in cash and futures segment of the equity market) dropped significantly and was even negative for a few days. In June 2020, this adverse phenomenon was repeated, prompting the outflows in July 2020. A section of investors would have thought that there is something wrong with the concept of arbitrage itself. And that precisely is the point we are making: fluctuations will happen. Choose arbitrage funds with an adequate horizon and things will smoothen out.

Understanding arbitrage funds 

A majority of the returns of arbitrage funds, 65 percent to be precise, comes from the differential in price between the cash / spot and stock futures segments of the equity market, for stocks that are available in the futures segment. This return is not dependent on the bullishness of equity market – unlike regular equity funds whose returns come from stock prices moving up.

This differential in pricing between the two segments depends upon multiple factors such as interest in futures, demand and supply from traders’ proprietary books, FIIs, Mutual Funds, etc. The spread is volatile, and not comparable to the coupon on bonds. Hence, to the extent of 65 percent of the portfolio, returns can be more volatile than fixed-income funds, or less volatile, depending on market conditions. The balance 35 percent is invested in money market / debt market instruments and cash equivalents. The cash equivalent portion also provides for the margins required for taking the stock futures positions.

Why is it not a liquid fund substitute?

In liquid funds, though there is some mark-to-market impact – returns move in line with the money market levels – most of the returns come from accrual, i.e., the coupon accruing on the instruments in the portfolio. In arbitrage funds, in the 65 percent component, fund managers buy the stock in the cash / spot segment and take a short position in the monthly futures contract. To that extent, once a position is taken for a month, returns are more-or-less visible. However, on the last Thursday of the month, when the contract expires and fresh positions are taken for the next month, the “roll-over” for the next month may happen at a much higher or much lower return level than for the previous month.

Over a long period, say one year, these fluctuations tend to even out. Another aspect of cash-futures arbitrage is that there is a daily mark-to-market component, which we saw in March and June last year – returns going negative for a temporary phase. This volatility can be much higher than in liquid funds. To reiterate, these performance fluctuations even out over an adequate horizon. Hence, it requires an adequate investment horizon and is in no way comparable with the seven-day investment horizon of liquid funds.

Conclusion

The appeal of arbitrage funds stems from the reasonably stable returns (over adequate horizon) and their taxation as equity funds, since 65 percent or more is invested in equity stocks. In the growth option of arbitrage funds, over a holding period of more than one year, the tax rate is 10 percent plus surcharge and cess. In debt funds, you need a holding period of three years in the growth option for tax efficiency. Of late, there has been some improvement in the performance of arbitrage funds, prompting the inflows. As of July 2021, the AUM of this category stands at more than Rs 1.1 lakh crore, against Rs 72,000 crore in July 2020. The category is safe to invest; just have the right perspective.

Source: https://www.moneycontrol.com/news/business/personal-finance/why-arbitrage-funds-arent-substitutes-for-liquid-schemes-7419491.html