Arbitrage Mutual Funds: As the interest rates rise, many are moving to arbitrage funds for the short term. Should you join them?

When it comes to parking funds for the short term, the average investor prefers liquid, overnight or ultra-short-term funds. However, of late some investors are looking at arbitrage funds, given equity taxation and exposure to money market yield. Though it can improve post-tax returns, the volatility involved in such investments cannot be ignored.

Arbitrage funds for short term

Arbitrage funds look to capture the difference in price in the spot market and that in the futures market. If a stock quotes at Rs 100 in the spot market and the same trades at Rs 100.50 in futures, then the fund manager looks to buy it in the spot market and simultaneously sell it in the futures market. By the time of expiry the prices converge and the fund manager reverses the transaction and pockets the price differential (technically known as spot future spread) minus transaction costs. The idea is to avoid stock market risk and focus on the arbitrage—the price differential. Arbitrage funds have given 3.49 percent returns over the year ended May 20, according to Value Research.

Though these schemes work better for an investor with a minimum timeframe of one year, many are looking at it for the very short term, typically up to three months. Monthly data from the Association of Mutual Funds in India also shows sizeable redemptions at the end of each quarter, just like other short-term-focused products such as liquid, ultra-short debt funds. Arbitrage funds saw net redemptions of Rs 4,303 crore and Rs 6,796 crore in December 2021 and March 2022.

Volatility in returns

But investors have to be careful while using any mutual fund product for short-term parking of funds. A look at the monthly returns make it clear that they are not consistent.

Though liquid and ultra-short-term funds are used to park money for the short term, the marked to market impact on the bonds held by these schemes cannot be ruled out, especially in times of swift upward movements in yields. For example, in the two weeks to May 17, ultra-short debt funds lost 0.14 percent. Despite volatility in the bond market, though, since January 2019, liquid and ultra-short debt funds have never lost money in any calendar month.

But the arbitrage funds’ monthly returns have been more volatile. When the stock market turns volatile, in the worst case, arbitrage funds can lose money. For example, in June 2020 and July 2020 these funds lost on an average 0.16 percent and 0.1 percent, respectively.

“We have historically seen volatility creeping in every three months by some known and some unknown domestic or international events,” says Sailesh Jain, fund manager, Tata Mutual Fund.

What to expect

Since arbitrage funds do not hold any long-term bonds, they do not take a hit from rising interest rates but benefit from rising short-term rates. The short-term yields generally act as a parameter of cost of funds and is one of the key inputs in deciding the premium at which the future price of a stock trades, compared to the spot price. This means arbitrage funds tend to track the very short-term yields and can offer better returns in a rising interest rate regime.

Another thing that needs to be factored in is the amount of money chasing spot-futures arbitrage opportunities. “Proprietary desks of brokers, foreign institutional investors and other market participants may also be chasing these opportunities along with mutual funds. Though it is not easy for an average investor to figure out the quantum of money being laid upon this strategy, investors need to keep an eye on the monthly spot-futures spreads to figure out if the strategy is still attractive or consult their advisors,” says Joydeep Sen, corporate trainer (debt).

If the broad market has exhibited severe selling, then the prices of stocks in the futures market start quoting at a discount to the spot price and in such cases the spot-future arbitrage opportunity vanishes. Though such situations are rare, an investor may come across a sideways market with negative bias wherein few stocks are quoting at an attractive premium in the futures market compared to the spot market, leading to relatively lower returns.

In the medium term, the investors should expect a well-managed arbitrage fund to offer money market returns.

What should you do?

Gains booked on units of arbitrage funds attract equity taxation. If the gains exceed Rs 1 lakh on units held for more than one year, they are taxed at 10 percent rate. For units held for a shorter period, the gains are taxed at 15 percent. This is better than the tax treatment for interest on fixed deposits and gains booked on units of debt funds held for less than 36 months, where the gains are taxed as per the slab rate.

But you should never consider these schemes as an ideal parking place for short-term funds or an alternative to liquid funds. And there are reasons for the same.

“An arbitrage fund generates the bulk of its returns by initiating arbitrage trade including rollovers and a part of its returns are also generated by capturing the intra-month volatility. On an average, a period of three months and beyond gives the investment enough time to settle in the trade and higher chances to enhance the return by capturing the market volatility,” says Jain.

Sen advocates an investment horizon of at least six months and ideally of one year to ensure that you are not caught on the wrong side of the volatility.

Parul Maheshwari, a Mumbai-based certified financial planner, advises against using arbitrage funds as an alternative to liquid funds. “There could be interim volatility in arbitrage funds which could eat into returns and, hence, it should not be used as an alternative to liquid funds,” says Maheshwari. Also, when you redeem money in liquid funds, the proceeds come back on the next working day, but in arbitrage funds it takes t+3 days, so it may not serve the purpose of a liquid fund which in many cases is used as an emergency fund, she adds.

Though the equity taxation enhances the returns potential of arbitrage funds, be prudent by investing with a one-year timeframe in these schemes.