Can arbitrage funds recover after a disastrous 2022?

Arbitrage funds have had a tough 2022. Between April and November 2022, the collective assets under management (AUM) of the category went down by 25 percent. These funds have been rocked by large-scale net redemptions of Rs 26,015 crore over the same period. However, going by the commentary of some of the fund houses and recent performance, it looks like the worst may be behind for the schemes.

What caused flight to safety?

Before we get into why these schemes look attractive, a quick recap would help set the context right.

For beginners, arbitrage funds aim to capture the difference between the price of a stock in the cash market and in the futures segment. The fund manager simultaneously buys a stock in the cash market and sells the same quantity in futures, to lock in the differential. As the prices converge towards expiry, the trades are reversed. When the futures price quotes at a premium to the spot price, there is money to be made.

Arbitrage funds were caught in the volatility phase of the equity markets. A downward trending market leaves these schemes scrambling for investment opportunities. In a falling market, many stocks, in the futures segment, quote at a discount to the spot prices. That makes these schemes bleed or generate very low returns. For example, in July 2022, arbitrage funds on an average lost 0.05 percent, and in March 2022 made only 0.04 percent returns, as per Value Research data.

Though the schemes have bounced back in the last four months along with the rebound in the equity markets, the returns were tepid. For example, in November 2022, though liquid funds gave 0.52 percent returns, arbitrage funds gave only 0.36 percent returns. Low returns with relatively less visibility of returns made many investors look for greener pastures in a rising interest rate environment.

What changed?

A look at December month numbers however, show a different picture. Arbitrage funds posted 0.63 percent returns compared to 0.54 percent given by liquid funds. Even January numbers are expected to be better. “Arbitrage funds have captured a spread of approximately 7 to 8 percent in December 2022, which is much better than liquid funds in the current scenario,” says a note from Edelweiss Mutual Fund.

Deepak Gupta, Fund Manager, Invesco Mutual Fund, foresees good times for arbitrage schemes, “because of higher arbitrage spreads due to higher interest rates in the economy, buoyant economic data in India (namely, GST collections, electricity consumption, petrol and diesel sales) supporting the equity market, and reduced corpus of the arbitrage industry”.

When less money is chasing the spot-future arbitrage opportunities, the price differential remains attractive.

“We have been seeing certain investors moving money out of short-term instruments, such as arbitrage funds, and liquid funds to lock into high-yielding longer-tenure deposits. This has contributed to arbitrage industry AUM coming down sharply over the last few quarters, effectively improving the demand-supply significantly for arbitrage yields,” says Asit Bhandarkar, Senior Fund Manager, Equity, JM Financial Mutual Fund.

Going forward, if the markets keep trending up or move sideways, then investors may make decent returns on these schemes. On the one hand, improved yields on arbitrage opportunities, and on the other hand, high yields on fixed-income investments held by these schemes, make arbitrage funds an attractive investment alternative.

Tax angle

Though the liquid funds and ultra-short duration funds have been offering high yields, they are taxed as per the slab rate if the units are held for less than three years. That makes the post-tax returns unattractive for most investors in the high income tax slab.

Instead, capital gains booked on arbitrage funds after holding the units for one year are considered long-term capital gains, and taxed at 10 percent. Otherwise, the gains are taxed at 15 percent.

Investors in the higher income tax bracket may want to prefer arbitrage funds over other short-term alternatives such as liquid, overnight and ultra-short-duration debt funds.

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What should you do?

Arbitrage funds have shown periods of poor returns for investors when the markets turn volatile. However, they cannot be written off completely.
Bhandarkar says, “Prospective investors should bear in mind that returns of the arbitrage category however, can be slightly more volatile than comparable products.”

This means that arbitrage funds aren’t an automatic alternative to liquid funds if you are just looking for an equity taxation alternative. Arbitrage funds work on a certain, albeit more complex, principle.

The only way to overcome the volatility in returns is to remain invested for a relatively long term compared to a liquid fund. Around six months of investment time horizon should work. For those who are keen to hold for a year, things turn better as they pay less tax.

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Parul Maheshwari, a Mumbai-based Certified Financial Planner, expects arbitrage funds to deliver 50 to 100 basis points (bps) higher returns than that of liquid funds. “Investors in high income tax slabs keen on equity taxation should look at arbitrage funds,” she said.

But remember to check both the expense ratio and exit loads of the scheme before investing.