Arbitrage Funds: When Both Bond & Equity Markets turn Risky

Arbitrage Funds

Arbitrage Funds are open ended mutual fund schemes which invest predominantly in arbitrage opportunities in equities. SEBI has stipulated that these funds have to maintain a minimum investment of 65% of their total assets in equity related instruments and the remaining portion can be invested in debt or Money Market instruments

Most arbitrage funds exploit Arbitrage opportunities by taking contrary positions between the equity market and the futures and  options market.  Although these schemes invest in equity markets, the expected returns are more in line with liquid funds.

In the aftermath of IL&FS event that lead to turmoil both in equity and debt markets, many market players switched over at least for the short term to Arbitrage Funds as they are potentially better insulated from both equity and Bond markets.

Salient Features of Arbitrage funds:

  • The Investment objective of Arbitrage schemes is to generate income by taking advantage of arbitrage opportunity that potentially exist between cash and derivative market and also within the derivative segment.
  • While minimum 65% of the corpus is invested in such Arbitrage opportunities, the balance is generally allocated to debt securities and money market instruments. 
  • Due to 65% of equity portion (which is hedged), Arbitrage funds enjoys the status of Equity funds.
  • Arbitrage Mutual funds have to limit position their position to a maximum of 10% in each stock arbitrage opportunity.
  • Before 2018 Budget, Long Term capital gains on more than one year of holding was nil, which used to make arbitrage funds tax free after one year holding. This advantage is now no more available.

Why Invest in Arbitrage Funds

  • Fund managers in arbitrage funds, reduce the risk of stocks held by hedging against the derivatives. Thus their equity exposure is more or less risk free
  • While Returns from Arbitrage funds are more less in line with Liquid fund and can at times be lower, gains from Arbitrage funds by virtue of their treatment as equity products are treated as Short-term capital gains if booked within one year or else long term capital Gains. Short term capital gains are taxed at 15% which is an advantage compared to Liquid Funds or Banks FDs where the interest is clubbed with the total taxable income and taxed as per ones’s income tax slab. 

Comparison of Some Arbitrage Funds:

We are taking four funds which have done better than category average of short term funds, and also have reasonable AUM and history. All funds are Direct growth option which we consider good for investors unless one is very much particular to get periodic income.

These Arbitrage Funds are

  1. Kotak Equity Arbitrage Fund – Direct Plan-Growth
  2. Reliance Arbitrage Fund -Direct-Growth
  3. IDFC Arbitrage Fund – Direct-Growth
  4. Axis Arbitrage Fund – Direct-Growth
ParticularsKotak ArbRel. ArbIDFC ArbAxis Arb
AUM  Rs. Cr13188987527852215
Expense Ratio0.44%0.25%0.34%0.25%
Exit Load.25% < 1m.25% < 1m.25% < 1m.25%< 1W
Returns 1m %0.500.590.560.54
Returns 3m %1.561.691.651.74
Returns 6m %3.353.453.433.43
Returns 1y %6.827.427.066.92
Returns 3y %6.806.976.766.99
  • As on date (14/01/19), Reliance Arbitrage fund has been able to deliver better historical returns than other comparable Arbitrage Funds over most of the periods. This however may not be true for all periods. The fund has the 2nd highest AUM after Kotak Arbitrage Fund and has one of the lowest expense ratio.
  • The other Three funds have also performed reasonable well in different time spans.
  • The tax treatment for Arbitrage funds is like Equity as they maintain more than 65% in equity and related securities. On account of this fund returns booked with in a year are taxed at 15%. If these funds are held for more than a year, 10% tax is applicable making them more tax efficient for those in high income brackets.
  • Arbitrage spreads are generally related to short term or overnight interest rates and thus the returns produced by these funds may many time mirror the prevailing short term interest rates.
  • Arbitrage Funds have good potential to offer comparable returns to bank fixed deposit and Liquid Funds. The return could range between 6%-7.5%, depending on volatility in stock markets, short term interest rates etc. Taking into consideration various befits like favorable Tax treatment esp. for those in higher tax brackets, No TDS, applicability and Tax only when redeemed i.e. ability to defer tax to subsequent date, Arbitrage funds merit a consideration in one’s investment portfolio as a low risk option which are insulated from gyrations in equity markets and even bond market risks to considerable extent.
  • The income from Arbitrage funds being either in form of Short term gains or Long terms gain and can be set off against against One’e short term / long term gains which can be handy in times when equity market are in bad shape.
  • In general Arbitrage funds have performed better when markets are volatile.

Standard disclaimer:  I am not a SEBI registered analyst and above analysis is for educational purpose only. Iam Certified in NISM-Series-V-A: Mutual Fund Distributors Certification Examination  but not involved in selling of any mutual fund products. I may have bias/vested interest in covered Stock/Funds/NCD etc. due to my own investment or  leaning. Further my understanding of the areas on which I write may be imperfect or incomplete. Please do your own due diligence as stock market/MF investments have high degree of inherent risk.

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