‘Arbitrage funds make the most sense for those in the 30 per cent tax bracket, are viable for those in the 20 per cent bracket, but less so for those in the 10 per cent bracket.’
With debt mutual funds losing their tax advantage, many savvy investors have turned to arbitrage funds, causing assets under management (AUM) in this category to rise from Rs 71,106 crore on April 30, 2023, to Rs 198,981.2 crore on October 31, 2024 — an increase of 179.8 per cent.
How do they work?
Arbitrage funds capitalise on price differences between the spot and futures markets.
“They buy stocks in the cash market while simultaneously selling them in the futures market,” says Arun Kumar, head of research, FundsIndia.
They allocate 30 to 35 per cent of their portfolios to short-term debt securities, primarily AAA-rated or government bonds, with duration under one year.
Arbitrage ensures a predictable return as the difference between the buying and selling price is locked in at the time of trade.
“Arbitrage means risk-free return. By definition, you should not lose money on an arbitrage transaction,” says Deepesh Raghaw, a Securities and Exchange Board of India registered investment advisor.
Their pre-tax returns are generally comparable to liquid funds over six months to a year.
Tax advantage
Arbitrage funds are more tax-efficient than debt funds.
“The 2023 Budget removed tax indexation benefits for debt funds, subjecting returns to the investor’s slab rate, which can reach 42.7 per cent for high net-worth individuals,” says Alekh Yadav, head of investment products, Sanctum Wealth.
“In contrast, arbitrage funds are taxed as equity-oriented funds at 12.5 per cent (if held for more than a year),” adds Yadav.
Gains could be tax-free if under Rs 1 lakh in a year.
Limited opportunities
Arbitrage funds do carry some risks and limitations.
“When price differentials between spot and futures are low, or futures trade at a discount, fund managers may hold cash or invest in low-risk debt, potentially leading to suboptimal returns,” says Kaustubh Belapurkar, director of manager research, Morningstar Investment Research India.
Kumar notes that minor, short-term declines may occur in bearish or flat markets, though arbitrage funds typically yield positive returns over 3 to 6 months.
“Arbitrage funds do not provide the day-to-day predictability of returns that investors might expect from a traditional debt fund,” says Raghaw.
“FII (Foreign Institutional Investor) participation also affects spreads: Reduced FII activity can improve spreads, and vice versa,” says Kumar.
As more money flows into arbitrage funds, competition for limited opportunities can drive spreads down.
Who should invest?
Tax benefits make arbitrage funds an attractive alternative to debt funds for HNIs.
“Arbitrage funds make the most sense for those in the 30 per cent tax bracket, are viable for those in the 20 per cent bracket, but less so for those in the 10 per cent bracket, who may go for liquid funds,” says Kumar.
For those tolerant of occasional, small, temporary dips, arbitrage funds can complement liquid funds in an emergency bucket.
Kumar recommends liquid funds for quick, volatility-free liquidity.
Selecting the right fund
Compare expense ratios and historical rolling returns.
“Comparing rolling returns over six-month or one-year periods helps gauge how consistently the fund manager has captured arbitrage opportunities,” says Belapurkar.
Raghaw suggests choosing larger schemes for their diversification, which helps manage risks.
Kumar recommends checking the credit quality of debt holdings.
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Feature Presentation: Ashish Narsale/Rediff.com