Arbitrage funds have seen some revival in investor interest in recent times. Most often these funds have been pitched to investors as an alternative to debt funds for parking short-term surpluses, given their tax advantage.
Are the seemingly risk-free arbitrage funds a better alternative to shorter duration debt funds?
Yes to some extent, if we go purely by the post-tax returns. But, the answer to this question is not simply a matter of comparing their post-tax returns. There is more to it.
Several factors such as equity market sentiment, the size of the arbitrage market, participation by FIIs and the prevailing interest rates come into play when we talk of arbitrage funds. Investors can not ignore these factors that contribute to the unpredictability and near-term volatility of returns, before deciding to invest in arbitrage funds.
Before we get to the details, here’s a quick recap of these funds.
Ultra short and Low duration funds and Money market funds – Ultra short duration funds invest in debt and money market instruments such as commercial papers, certificates of deposit, treasury bills etc. so that the average maturity of the portfolio at a point in time is 3-6 months. For Low duration funds, this must be 6-12 months.
Money market funds, as the name suggests, invest in money market instruments with a maturity of up to a year. As long as they invest in high credit quality papers (AAA and above), all these debt funds are a safe option.
Arbitrage funds – are funds that generate returns by engaging in arbitrage opportunities and taking advantage of the spread or the differential in the price of a stock in the spot market (that is the stock market) versus its price in the futures market. Most stocks generally trade at a premium in the futures market (unless the market sentiment turns very bearish) and this provides the spread.
See the tables below if you’d like some details on how this works.
How stock-futures arbitrage works
- Suppose a fund buys the stock of company ABC at Rs.200 & also sells the ABC stock futures at Rs.201
- The fund can continue to hold its position till the expiry of the futures contract. Alternatively, it can close the contract or roll it over to say the next month, before the expiry date.
Here are two simple examples:
(has gone up from the original price) | (has gone down from the original price) |
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|---|---|---|---|
Stock is sold | Futures contract is automatically settled | Stock is sold | Futures contract is automatically settled |
| Note: On expiry date - the stock price and the futures price converge. Also, we assume zero transaction costs which must otherwise be deducted from the net gain. |
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Stock futures trading at Rs. 214 (on the day the contract is closed) |
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|---|---|
Stock is sold | Contract (originally sold) is closed by buying the same futures contract |
| Note: On dates other than the expiry date - the stock price and the futures prices are likley to be different. |
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Arbitrage funds therefore do not face the risk of stock calls going wrong like it’s with equity funds.
This however does not mean they are risk-free. More on this a little later in the article.
For the moment, let’s address the question of how arbitrage funds fare versus shorter-term debt funds on the return front?
For our analysis, we have compared the average return of the 5 largest arbitrage funds with that of the 5 highest-credit quality (100% AAA) shorter-term debt funds. We have taken the 3-month (3M), 6-month(6M) and 1-year (1Y) rolling returns over the last 10 years (approx.).
Arbitrage funds taken – Kotak Equity Arbitrage Fund, IDFC Arbitrage Fund, SBI Arbitrage Opportunities Fund, ICICI Prudential Equity Arbitrage Fund and Nippon India Arbitrage Fund. Shorter-term debt funds taken – Aditya Birla Sun Life Money Manager Fund, Kotak Money Market Fund, ICICI Prudential Money Market Fund, HDFC Money Market Fund and IDFC Low Duration Fund
Given that arbitrage funds usually require a 3-6 month time frame to tide out intermittent volatility if any, we haven’t looked at the sub-3-month returns.
What do we find?
Pre-tax returns
On a pre-tax basis, arbitrage funds have been under-performers over the last 10 years. That is, their average return has been lower than that of shorter-term debt funds. For instance, it was lower by 0.9% points for the 1Y period.
They have outperformed shorter-term debt funds only 23% (3M), 16% (6M) and 9% (1Y) of the time in the last 10 years. See the table for more details.
| Return / Ouperformance | 3 Months | 6 Months | 1 Year |
| Arbitrage fund average return (A) | 1.8% | 3.7% | 7.5% |
| Short-term debt fund average return (B) | 2.0% | 4.1% | 8.4% |
| Average outperformance of Arbitarge funds (A-B) | -0.2% | -0.4% | -0.9% |
| Minimum outperformance of Arbitarge funds | -1.0% | -1.7% | -2.4% |
| Maximum outperformance of Arbitarge funds | 1.1% | 0.8% | 0.6% |
| % of times Abitrage funds outperformed Short-term debt funds | 23% | 16% | 9% |
| Note: All calculations are based on rolling returns over the last 10 years. |
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| Source: MFI Explorer, FundsIndia Research | |||
When post-tax returns are considered, a different picture emerges!
Not so taxing
Arbitrage funds are treated as equity funds for taxation purposes. That is, short-term returns (less than 1 year) are taxed at 15% plus surcharge and cess, while long-term returns (1-year and above) are taxed at 10% plus surcharge and cess. Further, the 10% tax applies only on returns in excess of Rs. 1 lakh a year for an individual.
After the cess and surcharge are included, the 15% short term capital gains tax translates into 15.6% for those in the 5% and the 20% tax brackets and 17.16% (or 17.94%) for those in the 30% tax bracket depending on how high their income is. Likewise, the 10% long term capital gains tax translates into 10.4% and 11.44% (or 11.96%). The surcharge applies to only those with incomes over Rs.50 lakh.
Returns from debt funds, on the other hand are taxed at an investor’s income tax slabs – 5% (5.2% after cess) or 20% (20.8% after cess) or 30%, assuming the old taxation regime.
For those in the 30% tax bracket (where income exceeds Rs. 50 lakh), there is a surcharge apart from the cess. After these are added, the tax rate could go from 31.2% at the lowest end to 42.744% at the highest.
Post-tax returns
Even after the tax on returns is taken into account, those in the 5% and 20% tax brackets are better-off with shorter-term debt funds. This is irrespective of the time period (3M, 6M or 1Y).
For those in the 20% tax bracket and with long-term capital gains not exceeding Rs. 1 lakh a year, the outperformance percentage for arbitrage funds goes up to 82%. This is due to the exemption from the 10% tax. But even then, the average outperformance remains fairly low. See the table below.
Return / Ouperformance
(10% tax on arbitrage funds)
(no tax on arbitrage funds)
(10% tax on arbitrage funds)
1 Year*
(no tax on arbitrage funds)
Arbitrage fund average return (A)
Short-term debt fund
average return (B)
Average outperformance of Arbitarge funds (A-B)
Minimum outperformance of Arbitarge funds
Maximum outperformance of Arbitarge funds
% of times Abitrage funds outperformed Short-term debt funds
Note: All calculations are based on rolling returns over the last 10 years. They also take into account the applicable cess on the 5% and 20% tax brackets.*Long-term capital gains (from sale of equity shares and MFs) of up to Rs. 1 lakh a year are exempt from the 10% tax.
Source: MFI Explorer, FundsIndia Research
It’s however different for those in the 30% tax bracket. For them, arbitrage funds beat shorter-term debt funds (particularly 1-year returns) nearly all the time. For those at the highest tax level – with incomes of over Rs. 5 crore, arbitrage funds outperform not just over the 1-year but also the 3-month and 6-month periods. Though the average outperformance is fairly low for the sub 1-year periods. See the table below.
(no surcharge) | Rs. 50 lakh & Rs. 1 crore (lowest surcharge) | (highest surcharge) |
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| Return / Ouperformance | |||||||||
| Arbitrage fund average return (A) | |||||||||
| Short-term debt fund average return (B) | |||||||||
| Average outperformance of Arbitarge funds (A-B) | |||||||||
| Minimum outperformance of Arbitarge funds | |||||||||
| Maximum outperformance of Arbitarge funds | |||||||||
| % of times Abitrage funds outperformed Short-term debt funds | |||||||||
| Note: All calculations are based on rolling returns over the last 10 years. They also take into account the applicable cess on the 5% and 20% tax brackets.*Long-term capital gains (from sale of equity shares and MFs) of up to Rs. 1 lakh a year are exempt from the 10% tax. |
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| Source: MFI Explorer, FundsIndia Research |
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Bumpy ride
While the slightly higher returns may be tempting, those in the higher tax brackets must keep in mind the high near-term volatility too. This can be gauged from the high number of instances of negative daily returns.
Further, arbitrage funds must invest a minimum of 65% in equity and equity-related investments. Another 15-20% must be in fixed deposits (for margin requirement) and the rest in debt/cash. It is therefore worth checking the credit quality of an arbitrage fund’s debt portfolio and the associated credit risk and duration risk.
Also as mentioned earlier, while arbitrage funds trade in equity markets, they don’t suffer from the same risks as equity funds. But, they do come with their own set of risks. Investors must consider the several risks associated with these funds before going for them.
What drives volatility and returns?
Arbitrage fund returns essentially depend on the spreads between the cash and the futures market. The spreads (which can shrink or worse still, turn negative) in turn are a function of several other factors which are ever-changing and may not be within a fund’s control. This makes the returns from arbitrage funds unpredictable and hence the volatility element.
Here are some factors that can impact the spread between the cash-futures market and so the returns from arbitrage funds:
Equity market sentiment turning bearish
Arbitrage funds do well in volatile markets (with bullish sentiment) because that’s when profitable arbitrage opportunities are easily available.
In bullish markets – FIIs, HNIs and retail investors increase their participation in the Futures & Options segment to take leveraged long bets. This increases the spread for short rollers like arbitrage funds.
In periods when markets are stable/range-bound and arbitrage opportunities dry up, such funds may have to stay invested in debt or hold cash. Also when the market sentiment is bearish, futures may trade at a discount (and not a premium) to the cash market implying negative spreads. In such situations, arbitrage funds will underperform. Take March (17th to 25th) this year for instance, when the stock markets hit all-time lows. Then, the cash-futures spreads turned negative on some of these days and so did the daily returns from arbitrage funds.
Industry size – bigger not better
With only a small number of stocks eligible for trading in the derivatives market based on SEBI regulations, the universe of stocks for arbitrage opportunities is limited. Though, as derivatives trading on more stocks is allowed, the arbitrage space can expand.
Further, as arbitrage funds grow their assets under management, the quantum of money scouting for arbitrage opportunities goes up and the spreads (and so the returns) tend to go down. Here’s some data.
At its peak, the arbitrage industry (65% of the AUM of all arbitrage funds that is in cash-futures arbitrage) accounted for half of the Rs. 1.1 lakh crore arbitrage market (measured by the total stock futures open interest). Today, the arbitrage industry is more than 52% of the arbitrage market (Source: Kotak MF).
For instance, if equity markets are overvalued BAFs may reduce their equity (stock market) exposure and up their derivatives market (stock-futures arbitrage) exposure to ensure that their total equity allocation stays at least 65% to be treated as equity funds for tax purposes.
Lower domestic interest rates
As interest rates fall, arbitrage returns too are likely to fall.
There are 2 reasons why this happens
- Investors going long on futures (who are responsible for the premium spread) can now borrow at a lower cost and hence take larger positions with the borrowed money leading to lower premium in futures.
- When interest rates come down then future debt fund return potential also comes down. But if the arbitrage spreads continue to be high, then money will move from debt funds to arbitrage funds, leading to more money chasing the same arbitrage opportunities and hence eventually leading to lower spreads and returns subsequently.
FIIs – currency hedging and borrowing costs matter
Lower INR hedging cost and borrowing cost reduce the arbitrage thresholds for FIIs, increasing their participation in the Indian equity arbitrage trades and consequently bringing down the spreads.
Those in the 30% tax bracket who want to consider arbitrage funds for their short-term surpluses should keep all these risks in mind.
Shell out more
Risks apart, arbitrage funds also come with significantly higher expense ratios compared to debt funds. For arbitrage funds, the expense ratio (for regular plans) is in the range of 0.9 % to over 1%. Shorter-term debt funds have a wider band of expense ratios ranging from 0.3% to over 1%.
Also, arbitrage funds attract an exit load of mostly 0.25% or 0.5% for exit before 30 days (15 days). Most shorter-term debt funds, on the other hand, have no exit load.
What we recommend
Investors in the 5% and 20% tax brackets are better off using shorter-term debt funds (Ultra Short Duration/Low Duration/Money Market funds) for their temporary cash surpluses (6-12 months) given that these funds have outperformed arbitrage funds and also have a more stable return trajectory. As long as you invest in debt funds that hold high credit quality papers (AAA-rated) in their portfolio, your capital is protected.
Those in the 30% tax brackets (especially with higher surcharge) may find arbitrage funds attractive for parking their money for 6-12 months’ time frame. However, given the near-term volatility as also the various factors that work to make arbitrage fund returns quite unpredictable, we prefer debt funds. But, if you can tolerate near-term volatility and understand the underlying factors driving arbitrage fund returns, you can opt for arbitrage funds for the slightly better post-tax returns.
It’s worth keeping in mind though, that as the arbitrage fund category grows in size (if the funds perform well and / or more investor money flows in), that in itself will work towards gradually driving down their returns over time. This is because with more money chasing the existing arbitrage opportunities, spreads will eventually narrow down.
For those with an investment horizon of longer than 1 year (all tax brackets), we recommend debt funds (high credit quality) given the stability and some predictability of their returns.
- Discontinuation of the Systematic Investment Plan (SIP) of the Designated Schemes of MOMF
- Change in Maximum Subscription Amount of Aditya Birla Sun Life Medium Term Plan
Wealth Conversations – December 2024
Are Arbitrage Funds right for you?- Introduction Of Daily, Weekly Frequency In Sip And Changes In Default Sip Date And Minimum Investment Amount For The Groww Mutual Funds
