FUND FLAVOUR

April 2021

Arbitrage Funds

Arbitrage funds work on the mispricing of equity shares in the spot and futures market. They take advantage of the price differences between current and future securities to generate maximum returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets.

Reasonable returns…

Return on arbitrage funds primarily stem from arbitrage opportunities, interest on deposits kept as margin collateral and interest on the remaining debt and liquid component. Margin money required for taking arbitrage position (i.e. future positions) in the market is, generally, kept in the form of short-term deposits, cash or cash equivalents in accordance with the regulations. Funds have to maintain enough balance to maintain that account on a daily basis. At the end of each trading day, the margin account is adjusted to reflect gain or loss depending upon the future closing price. Arbitrage opportunity is based on the spread, open interest and the margin needed for the position. The spread is the difference in the cost price and the selling price of securities. Open interest is the derivative positions that are not closed. Open interest provides a big picture of the trading activity in the market and whether there is increased or decreased participation. Usually, higher open interest enhances the chances of a healthy spread. The job of a fund manager is to identify the pockets of arbitrage opportunities from which to gain. Identifying opportunities may also mean identifying market-cap segments (large, mid) where the volatility is more. But the fund manager needs to balance that with the margins needed for such stocks. The fund manager may also rollover positions, i.e., carry forward the current futures position to the next series. In this process too, the fund manager may generate reasonable returns. Arbitrage funds need to invest at least 65% of the portfolio in equities and equity-related instruments so as to remain as an equity fund under tax laws and qualify for lower taxation rates, 10 to 25% in fixed deposits (for margin money) and 0 to 10% in debt and money market instruments (mainly TREPS). The returns of the investors may get moderated due to the higher transaction costs, higher trading volume and other fund expenses. The fund managers must explore and spot such arbitrage opportunities regularly to generate consistent returns for the investors. Further, in the periods with fewer arbitrage opportunities, the fund manager may also deploy the funds in fixed income securities, while maintaining the minimum equity exposure of 65% as required by the Securities and Exchange Board of India (SEBI) regulation.

 …with insignificant risk

 By their very nature, the portfolio of Arbitrage funds tends to carry hedged exposures. In simple terms, long exposures for security will be covered with a short position in the futures segment or at another exchange. By virtue of the investors not carrying open exposures for equity securities, investors are exposed to insignificant quantum of investment risk. The fund manager will ensure that the investments are made only in high-credit quality debt securities such as zero-coupon bonds, debentures and term deposits. This helps in keeping the fund returns in line with the expectations during the period of inadequate arbitrage opportunities. Apart from being an excellent investment option when the market is unstable, these funds historically are known to generate higher returns (approximately 8%), which is much higher than the traditional investment options like fixed deposits and savings bank accounts. Not to mention, arbitrage fund taxation is another reason why it is popular among investors. In a nutshell, arbitrage funds leverage market inefficiencies with an aim to reap benefits for investors.

Arbitrage Funds shine despite the hiccup

The calendar year 2020 was not reassuring for arbitrage funds.  A majority of them witnessed negative returns in May 2020, their worst monthly performance in 2020. In April and May 2020, the market sentiment was negative due to COVID-19. The one-year category returns—average returns of all arbitrage funds—fell to 3.6% as of January 1, 2021, according to data from Value Research. In the past three, five and ten years, these funds had an annualized return of 5.1%, 5.6% and 7.16%, respectively. Considering the risk-free nature of the investment, such returns may be deemed reasonable, as against the prevailing savings bank rate. In addition, they make sense for some investors depending on their tax bracket and investment horizon.

Safety under the scanner?

Arbitrage fund returns at times can be volatile or they can post a negative return on a single day due to mark to market (MTM) losses. This MTM loss can happen in both equity and debt portions. The mark to market valuation of equity portion of the portfolio happens daily till the expiry date. This valuation is benchmarked against the locked-in yield / rollover yield of the portfolio which in turn decides the return for the day. So, even if the market has gone up or down on a single day, the portfolio movement can be opposite till the existing positions are closed and new rollover yield is locked-in from the previous level of locked in yield of the portfolio. There can be volatility or negative returns due to debt portions as well because of MTM and higher duration paper. The above scenarios can drive arbitrage fund to post a negative return. However, one single day return can be an outlier and may not be worthwhile to measure fund’s consistency over a period of time.

Arbitrage funds are relatively safe, and carry little risk. The risk of equities is reduced by hedging against derivatives. However, there are certain inherent risks attached to arbitrage strategies and factors like lack of arbitrage opportunities, their perfect execution and the liquidity in the stock/cash and futures segments can contribute to the uncertainty and risk. If you invest in low rated debt instruments, there are some risks like default risk and rating downgrade risks.

Arbitrage funds make profits from low-risk buy-and-sell opportunities in the cash and futures market. Their risk level is comparable with that of a pure debt fund. Several arbitrage funds follow CRISIL BSE 0.23% Liquid Fund Index as their benchmark. These funds are apt for those investors who are looking to have equity exposure but are worried about the risk associated with the same. Arbitrage funds are a safe option for risk-averse individuals to safely park their surplus funds when there is a persistent volatility in the market.  

Preferred fund parking spaces…

Arbitrage funds as a category saw strong growth in the previous financial year, as investors sought pockets of safety with credit risks taking a toll on debt schemes. Since the beginning of the last financial year, the asset base of arbitrage schemes has risen about 71 per cent — from Rs 50,839 crore to around Rs. 87,000 crore in February.

The bottomline…

If you redeem your investments in an arbitrage fund for up to one year, the profits will be taxed as short-term capital gains (STCG). The tax treatment of arbitrage funds is the same as any other equity fund. You will pay a tax of 15% on STCG. In the case of liquid funds (or debt schemes), profits are taxed as STCG for up to three years. If you withdraw before three years, your gains are clubbed with your income and tax is payable at the marginal rate. If you are in the 20% or 30% tax bracket, and if returns from liquid and arbitrage funds are the same, your post-tax returns would be higher in the arbitrage funds if you withdraw within three years of investing. If you redeem after one year, there is no tax for profits up to Rs.1 lakh. Any gains over that are taxed at 10%. If you are in the highest tax bracket, in specific circumstances, it may still make sense to invest in arbitrage funds. Their one-year returns are on par with that of liquid mutual funds. If you are investing in an arbitrage fund, keep a minimum six-month horizon, and do not worry about short periods of negative returns. The way the product is structured, they do not give negative returns if you hold them for over six months. In certain market conditions, arbitrage opportunities are limited. If you ride it out, you can still make better post-tax returns in arbitrage funds over short-term debt funds.

Advance tax payment obligations, deterioration in asset quality, potential risk of defaults in the COVID -19 lockdown and heightened volatility in the Indian debt market are some of the key reasons for outflows from debt-oriented mutual fund schemes. Unprecedented redemptions in the Arbitrage Funds and Liquid Funds, as well as the net inflows recorded by the overnight funds, suggest that investors preferred safety over returns. Liquidity is a key concern as the world continues to fight the COVID-19 pandemic. If you have an extreme short-term time horizon (of 3 to 6 months), consider a Liquid Fund with high-quality debt papers, which does not have high exposure to Commercial Papers (issued by private entities). Alternatively, if you wish to park in a much safer category, you would be better off investing in Overnight Funds. To park money for the short-term for an investment time horizon up to 1 year, you may consider investing in an Arbitrage Fund.