Should mutual fund investors consider investing in arbitrage funds?

An arbitrage fund is a category of equity mutual fund that leverages the price differential in the cash and derivatives market to generate returns

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Financial planners recommend this class of equity funds to investors who are looking for tax-efficient returns and have a time frame of atleast one month

What is an arbitrage fund?
An arbitrage fund is a category of equity mutual fund that leverages the price differential in the cash and derivatives market to generate returns. The fund manager simultaneously buys shares in the cash segment and sells futures in the derivatives segment of the same company as long as the futures are trading at a reasonable premium. The scheme does not take a naked exposure to any individual company or an index as each buy transaction in the cash market has a corresponding sell transaction in the futures market.
  • 10.76%Annualized Return for 3 year
  • >3 years Suggested Investment Horizon
  • 3.7 YearsTime taken to double money

Why is there investor interest in this category?
Investors like arbitrage funds because they are treated as equity funds from a taxation perspective. Investor interest has shifted to this category after the long-term holding period for debt funds was increased from one to three years. Since arbitrage funds maintain an average exposure of more than 65 per cent to equity, they are treated as equity funds, their holding period for long-term capital gain is one year. From April 2018, long-term capital gain from equity is taxed at 10 per cent.

Are arbitrage funds safe for investors?
Investors who are waiting for a correction in the markets before committing long-term money to equity can use arbitrage funds to earn some returns in the interim period. Though they are relatively low risk, the payoff can be unpredictable and could depend on the arbitrage opportunities in the market. This category ranks high in the pecking order when it comes to safety because the fund manager creates a market neutral position by buying in cash market and selling in futures. Higher the volatility, more are the opportunities for an arbitrager. With corporate earnings yet to pick up and valuations in broader market high, there could be increased volatility and hence they are a good bet.

What returns can an investor expect from this category of funds?
Returns from arbitrage funds depend on arbitrage opportunities available between the spot market and the futures market. Such opportunities are high in bull markets. As the assets under management in this segment increase, all this money will be chasing similar arbitrage opportunities and hence returns could be lower. Over the last one year, this category of funds has earned an average return of 6.07 per cent. Over a three-year period investors have earned a return of 5.78 per cent.
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