Why arbitrage funds got record inflows in July

Arbitrage schemes received record flows of Rs 14,924 crore in July, 2021. As per data from the Association of Mutual Funds of India (AMFI), arbitrage funds got Rs 20,826 crore in the March-June 2021 quarter, up from Rs 13,356 crore during January-March 2021 and just Rs 631 crore in the December 2020 quarter.

Experts say better post-tax returns offered by arbitrage schemes are making institutional investors switch from liquid to arbitrage schemes.

“Corporates are now looking at arbitrage schemes as an alternative to liquid funds,” says Rahul Singh, chief investment officer of Tata Mutual Fund, which manages a Rs 11,800-crore arbitrage fund.

In the one-year period, arbitrage schemes have given 3.6 percent returns on an average, slightly higher than the 3 percent managed by liquid funds.

Arbitrage schemes get better spreads in bull markets

Arbitrage schemes buy stocks and then sell their futures, to gain from the stock-future spreads. When markets are stable, future contracts usually trade at a premium to the underlying stocks.

“When markets are bullish as they are right now, the spreads in the arbitrage market tend to be wider, which offers better returns,” says Niranjan Avasthi, head-products, Edelweiss Mutual Fund, which manages a Rs-6,500-crore arbitrage fund.

However, as size of arbitrage schemes become larger with higher flows, spreads in the arbitrage market narrow.

“Arbitrage market size is limited. So, as size of arbitrage fund category becomes large, it reduces the potential spreads these funds can earn in the arbitrage market. This is a self-correcting cycle. As spreads reduce there are outflows from the category, its size reduces and spreads become attractive again,” Avasthi explains.

As of July 31, 2021, the overall size of arbitrage funds stood at Rs 1.08 trillion.

Should retail investors consider these schemes?

High networth investors (HNIs), as well as retail investors, can think of investing their short-term money in arbitrage funds as these are more tax efficient.

An arbitrage fund is treated like an equity fund for tax purposes. So, a Long-Term Capital Gains tax (LTCG) of ten percent is applicable if the investment is withdrawn after a year. The Short-Term Capital Gains (STCG) tax is at 15 percent.

The LTCG tax on liquid fund, which is a debt-oriented fund, is 20 percent. It is applicable if the investment is withdrawn after three years.

The STCG is taxed at the individual’s tax bracket. So, if the investor falls in the 30 percent tax bracket, the short-term gains will be taxed at 30 percent.

Rushabh Desai, a Mumbai-based MF distributor, who has been recommending arbitrage funds to his clients for parking their short-term money, says individual investors can invest in these fund as long as they are willing to stay put around six months to a years’ time.

“If markets turn bearish, it can impact spreads of arbitrage funds, as we have seen last year as well. But over a slightly longer period, the impact of market volatility usually evens out,” Desai says.