Arbitrage Funds: Arbitrage funds gain traction in the short term and offer better returns than debt

Mumbai: Investors looking to park money for an ultra-short period of between one and six months may consider arbitrage funds given rising spreads amid improving equity market sentiment and less money chasing arbitrage opportunities.

Fund managers and investment advisers say investors can enjoy higher returns than cash, along with better taxation.

“Arbitrage funds have the potential to earn 7-8% upfront costs, which is 100-125 basis points more than cash, making them a good option for investors with a 1-6 month investment horizon,” said Nirav Karkera, Research director at Fisdom.

This category had seen an exodus from wealthy investors and family offices with outflows of ₹31,000 crore over the past six months as yields contracted to 3% as money flowed into bank deposits and cash.

However, fund managers believe this is about to change as equity markets rally and arbitrage schemes reduce wealth.

“In the arbitrage space, there is an inverse relationship between assets under management (AUMs) and returns, with higher AUMs leading to lower returns. However, with lower AUMs and less pressure on short rollovers, spreads have improved,” said Bhavesh Jain, fund manager at Edelweiss Investmentfonds.

Recent rollovers have occurred with a spread of 70-80 basis points, which is expected to result in higher returns for investors. Analysts believe arbitrage fund spreads could remain elevated as liquidity is likely to remain tight through year-end and volatility is expected to remain high in January as investors build positions ahead of the Union Budget.

“Open interest, which was down to ₹60,000 crore in the April-June correction, has bounced back to ₹85,000 crore and as sentiment improves with long leveraged equity futures positions, the likelihood of returns in improve such funds,” he added Jaina.

Arbitrage funds profit from the price differential between spot and futures markets. These funds earn a spread by buying in the spot market and selling in the futures market.

Financial planners say investors waiting for a correction or staggering investments in stocks are using arbitrage funds as parking vehicles because they are taxed less than debt funds.

Arbitrage funds enjoy an equity tax, which means investors holding such a fund for less than a year pay a 15% capital gains tax. If they sell after a year, they only pay 10% long-term capital gains tax, resulting in higher after-tax returns. If high net worth individuals in a debt fund sell three years ago, they must pay short-term capital gains at the slab rate, which can be up to a maximum of 42% after adding premiums.