Are arbitrage funds still worth it?

Despite falling returns, tax-efficiency and low volatility are pluses

Can you name an investment that offers steady returns, carries zero risk of capital losses and is tax-free? Surprisingly there is one — equity arbitrage funds.

In the last five years, Indian mutual funds have dived into arbitrage trading in a big way, offering opportunities for retail investors to participate in this once-exclusive market segment.

Presently, there are two classes of mutual fund products that offer arbitrage returns. Pure-play arbitrage funds generate all their returns from arbitrage trading. Then, there are equity savings funds that combine plain equities, equity arbitrage and debt, in roughly equal proportions, to get you close to a double-digit return.

Both categories of funds fetch you tax breaks available for equity-oriented funds because over 65 per cent of their portfolio is invested in stocks.

How they work

Arbitrage traders use dozens of strategies to make their ‘spreads’ (returns), but mutual funds in India trade mainly on cash-futures arbitrage in individual stocks with liquid future contracts.

Assume that the ITC stock trades at ₹300 in the cash market, while its one-month future is changing hands at ₹301.50 on the same day. An arbitrage fund buys the stock in the cash market and immediately sells the one-month future, to pocket the ‘spread’ of ₹1.50. That’s an effective 0.5 per cent return. Repeating this trade every month helps the fund earn an annual return of over 6 per cent (assuming spreads remain the same).

Because a fund locks into the arbitrage spread at the outset and holds the contract to expiry, the returns are not influenced by market moves. One never loses capital because one has already locked into the return.

Returns can swing

Arbitrage returns can vary from month to month and year-to-year. In June 2015, arbitrage funds sported one-year returns ranging from 7.1 to 8.7 per cent, with a three-year CAGR of 8.5 per cent. But today (June 2017) returns are far lower, ranging from 5.5 to 7.3 per cent with the three-year CAGR at 7.2 per cent.

The returns from arbitrage funds, as a class, are influenced by three factors.

One, the spreads that can be made on cash-futures arbitrage can fall (or rise) with short-term interest rates in the market.

Two, the spreads are also dependent on the participants in the arbitrage market. There is significant foreign portfolio investor (FPI) participation in cash-futures arbitrage in India.

Fund managers explain that when FPIs enter the segment en masse, spreads shrink because their return expectations are lower than for domestic investors.

Three, arbitrage returns are also impacted by market conditions. If markets are volatile or bullish, traders are willing to pay higher interest costs to buy futures, widening the spread. Investors entering arbitrage funds today should keep their return expectations moderate at the 6-7 per cent.

Who should buy them

Arbitrage funds are most well-suited to investors in the 20 or 30 per cent tax bracket who are looking for a safe one to three-year parking ground for their money. It is tax-efficiency that makes arbitrage funds a superior option to liquid funds, despite their recent slump in returns.

While arbitrage fund returns are tax-free after one year, liquid fund returns suffer short-term capital gains tax at one’s slab rate for holding periods upto three years.

Effectively, a 6 per cent return on an arbitrage fund is equivalent to a pre-tax return of 7.6 per cent on a liquid fund, for an investor in the 20 per cent slab and 8.7 per cent for the 30 per cent slab.

The ability of arbitrage funds to generate safe and steady returns like clockwork is also an advantage for investors seeking regular income. Such investors can set up Systematic Withdrawal Plans for regular cash flow.

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