6 mins read . 17 Jan 2023
If you have been a keen follower of mutual funds, you would not have missed this category called arbitrage funds. Arbitrage funds, classified as a part of hybrid funds, offer a combination of equity and debt. Let us be clear that the returns of an arbitrage fund are similar to a short-term debt fund or a liquid fund. However, since the arbitrage fund holds stocks and sells futures against them, more than 65% of its portfolio comprises equities. This classifies arbitrage funds as equity funds and that gives them an added edge since equity funds are taxed at a concessional rate. However, returns on arbitrage funds are not guaranteed and are vulnerable to market risk. Let us turn to how arbitrage funds work.
An arbitrage indulges in arbitrage. It buys in the cash market and sells the same stock in the same quantity in the futures market. Normally, the futures trade at a premium to the spot rate due to the 1 month time period involved. By buying in the spot and selling in futures, this interest gap is locked in as assured arbitrage profits. At the end of the monthly expiry, this transaction can be unwound at the same price. However, in practice arbitrage funds rarely wind up their entire position. They hold on to the cash market position and keep rolling over the short futures position into the next month. Since short futures are rolled over at a spread, the arbitrage fund is able to encash the spread each month without selling stock.
What are the kind of returns that investors can earn on arbitrage funds? If you look at the Morningstar rankings, the top arbitrage fund by 5-year returns (IDFC Arbitrage Fund) has generated 5-year returns of 5.51% and 1-year returns of 4.96%. So the returns are about 5% for the top performer at the current juncture. If you look at the category average, the median 5-year return is 4.96% while the median 1-year return is 4.52%. In short, there is not much to choose and the returns are largely homogeneous. These are the direct plans that we are referring to and the regular plans should be getting lower returns. Occasionally, the arbitrage funds also unwind the arbitrage if the arbitrage goes into discount.
Are there any risks involved in an arbitrage fund or is it totally riskless? Remember, no market product can be truly riskless. Here is what you need to know about arbitrage fund risks.
Arbitrage is a popular product to park short-term funds. However, these funds run their risks too.