What Is an Arbitrage Fund All About

What arbitrage funds are all about?

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.

Table of Contents

1. What arbitrage funds are all about?
2. How exactly does an arbitrage fund work?
3. Risks in an arbitrage fund

How exactly does an arbitrage fund 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.

Risks in an arbitrage fund

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.

1. Arbitrage spreads can be volatile if the bond yields fluctuate. In such cases, the arbitrage returns can also be negatively impacted. In the previous year, the annual returns on arbitrage funds had gone to as low as 4%.
2. Arbitrage funds often indulge in selective aggressive strategies. For example, a fund manager may take a view on dividends or on spreads going negative. These kinds of risky strategies can often backfire and that is a risk.
3. Arbitrage funds run the VWAP risk. On the expiry date when you unwind arbitrage positions, you sell the cash position at close to the estimated final Value Weighted Average Price (VWAP). However, last-minute volatility can skew the VWAP and this has often resulted in losses for the arbitrageurs.
4. In arbitrage funds, as we said earlier, futures positions are normally rolled over. So, there is the rollover risk too. The spread between the current month’s futures and next month’s futures can often be volatile and arbitrage funds have to often roll over at an unattractive spread, which impacts the annualized returns.
5. Much of the tax benefits enjoyed by arbitrage funds due to their equity classification have diminished. For instance, long-term capital gains are not tax-free any longer. They are taxed at a flat 10% without the benefit of indexation. Also, dividends if declared by the arbitrage funds, are fully taxable at the peak rate in the hands of the investors. These changes have taken the sheen away from the equity classification benefit.

Arbitrage is a popular product to park short-term funds. However, these funds run their risks too.