Arbitrage Funds: Why you must be prepared for low and volatile returns

Contrary to the belief of many investors, arbitrage funds do not deliver stable returns. The returns from the strategy mainly depend on two key determinants – interest rates prevailing in the economy and price volatility in stock markets. The higher the rate of interest, the higher the cost of funding for the futures position. This gets reflected in the high premium investors need to pay for futures in a bullish market. In case the rates are low, the cost of carry and thereby the premium erodes for all derivative instruments.

If the price volatility is high with an upward moving bias, then you make more money in the cash-future arbitrage. But if there is a bearish sentiment in the market and the stock is quoting at discount in futures market or at a negligible premium, then there is little money to be made for mutual funds.

Arbitrage funds’ returns have been impacted by these two key factors. Daily rolling return for the one-year period has gone down to 3.98 per cent on October 7, 2020 for arbitrage funds as a category compared to 5.91 per cent as on January 1, 2020, as per Value Research data.

“As interest rates in the Indian economy have come down, other things remaining the same, the spreads between spot prices and future prices have also eroded accordingly. This in turn has reduced the returns on spot-future arbitrage in last few months,” explains Vijay Bhambwani, Editor, Equitymaster.com.

Availability of arbitrage

Over the years, the increased use of technology has led to enhanced availability of the information, which in turn makes spotting and capturing arbitrage opportunities easier. But there is a flipside. Sumeet Bagadia, Executive Director, Choice Broking points to the declining arbitrage opportunities over a long period of time. “The moot question is whether an investor will get arbitrage opportunities consistently.  In today’s time, where all the information is handy, this type of difference doesn’t exist for long,” he adds. He advises entering into such a strategy at the beginning of the month when there are relatively better opportunities.

Investors’ participation in the financial markets also need to be watched. “As the market recovered from the March lows, investor participation has gone up. It has ensured that there are enough opportunities for arbitrage funds,” says Sailesh Jain, Fund Manager, Tata AMC.

There are many ultra-high net-worth individuals along with institutions and proprietary desks of brokerages looking for arbitrage opportunities. If too many investors go for arbitrage and the pie does not expand, then one has to settle for less. A look at the assets under management (AUM) of the arbitrage funds can give you some idea.

After a panic exit, which led to a Rs 33,767 crore net outflow from arbitrage funds in March, investors came back with net investments of Rs 20,930 crore in the April-June period, as per data released by the Association of Mutual Funds in India.  However, as the returns taper down, investors are now seen exiting. In the three months ended September 30, 2020, investors have sold arbitrage funds worth Rs 8008 crore. The AUM of these funds stands at Rs 63,138 crore as on September 30, 2020 as compared to Rs 85,460 crore as on January 31, 2020.

Should you invest?

Arbitrage funds are suitable for the short term. Nitin Rao, CEO, InCred Wealth says, “As far as expected returns are concerned, arbitrage funds score above liquid funds and ultra short bond funds in a stable or upward trending stock markets.” Equity taxation makes returns delivered by arbitrage funds even more attractive, he says.

Profits in excess of Rs 1 lakh earned on units of arbitrage funds held for more than twelve months, are treated as long term capital gains and taxed at 10 per cent. In case investments are sold in less than one year, the gains are taxed at 15 per cent, which is less than the tax rates charged on bond funds.

But they cannot be used as a replacement for liquid or ultra-short bond funds. Vishal Dhawan, founder and chief financial planner of Plan Ahead Wealth Advisors says, “There is a possibility that opportunities in cash-future arbitrage may dry up for a month to three months in a year. Hence investors must have six to 12 months’ investment time frame.”

You should calibrate your expectation of returns downwards. If the short term rates remain range-bound with downward bias, as indicated by the RBI Governor, in the foreseeable future, then you too should not expect significant uptick in returns from these funds. Another risk that you cannot ignore is the downward volatility in the market. At times when the futures prices quote at significant discount to cash markets, returns from these funds take a beating.

For an arbitrage fund, high volatility is welcome. “Increased volatility in an upward trending market, such as the one we are into now, is a good entry point for investors in arbitrage funds,” says Jain.

If you are content with returns in excess of ultra short term bond funds and have a one-year investment timeframe, then arbitrage funds make sense for you. Investments in growth option of arbitrage funds can offer better post-tax returns.