Arbitrage funds are supposed to offer safe and steady returns. Do they?
Moneylife Digital Team
Arbitrage funds appear to be one of the best options in a volatile market for investors who wish to invest in a low-risk portfolio and yet earn decent returns. Theoretically, these funds benefit from the arbitrage opportunities arising out of price differences between the equity and derivatives segment of the stock market. But this does not ensure returns. But the real attraction of arbitrage funds is in post-tax returns.
How do they work? Suppose a stock is trading in the cash market at Rs400 whereas in the futures market its price is Rs410. An arbitrage fund will buy the stock in the cash market and simultaneously sell it in the futures market, locking a gain of Rs10. On the settlement day, it will reverse the transaction. If the price of the stock goes down, so will the price of the futures. No matter what the price of the stock, the fund will make a profit of Rs10 per share. On the date of expiry, when the arbitrage is to be unwound, the stock price and its futures contract of the current month coincide.
Arbitrage fund -
Though arbitrage funds are referred to as ‘risk-free’ investments, this is not strictly true because there is some risk in availability of arbitrage opportunities and their timing. A long bear phase may create problems because the arbitrage strategy of ‘buy stock, sell futures’ will not work if the future price of the stock is trading at a discount to its spot price—as is happening now. In addition to scarce arbitrage opportunities, margins tend to be low and the expense ratios are high, as such funds have to trade heavily. Each transaction in the stock market involves payment of brokerage and securities transaction tax (STT). These costs directly dilute the earnings. Each leg of the entire transaction, viz., buying stock, selling futures, selling stock and buying futures will entail the payment of these costs. Therefore, it again comes down to the availability of the arbitrage opportunity and it being attractive enough, i.e., after the payment of the expenses, the left-over profit (if any), should be material enough to make the transaction worth entering into.
Out of the 12 arbitrage schemes that have been around since 2008, only two have outperformed their benchmarks; three schemes have underperformed and seven schemes have just about managed to equal their benchmark returns. The arbitrage opportunity depends on the short-term interest rate and so does the performance of the CRISIL Liquid Fund Index which is the most popular benchmark index. The two outperformers are Benchmark Equity and Derivative Opportunities Fund and UTI-SPrEAD Fund. These have yielded 1%-2% higher returns. However, the key attraction of arbitrage funds is not returns, but the tax advantage—a point that we at Moneylife had missed earlier.
As arbitrage funds invest mostly in equity or equity-related instruments, they are treated as equity funds. So they attract lower short-term capital gains tax of 15% and are completely tax-free after one year of investment. Though the top-performing debt funds offer higher returns than arbitrage funds, debt funds don’t offer that tax advantage. Neither do bank fixed deposits.
However, this advantage is getting eroded in a situation of rising inflation and when bank interest rates are higher. An average return of 6% (tax-free) from arbitrage funds is not better than the fully taxed, but fixed and safe return of 9% offered by banks currently.