Investors are fleeing this mutual fund category. But is it already showing signs of recovery?

Arbitrage funds have been at the receiving end of a good-old battering this year, but can it find its legs again? Can they shoulder investors' expectations going forward? When we asked industry experts, they seemed positive.

Quick explainer of arbitrage funds
Arbitrage funds are types of mutual funds that profit on the price differences of a stock.

Let's say Stock A is priced at Rs 100 in the Bombay Stock Exchange (BSE), and Rs 102 in the National Stock Exchange (NSE). An arbitrage fund can swoop in and buy the stock from the BSE and sell it at a higher price in the NSE for a Rs 2 profit. This price difference is known as spreads.

Similarly, there may be a price difference between its current and future price too. For instance, the current price of Stock A might be Rs 100, but the futures market has it at Rs 110. This would give the manager of the arbitrage mutual fund to make a risk-free profit of Rs 10 when the current price matches the future price by the end of the month.

The story so far
Since the start of 2022, investors have sucked out around Rs 25,650 crore from these funds. The last four months have been particularly nasty: the net outflow stood at Rs 24,500 crore.

The reason? Kayzad Eghlim, the fund manager of ICICI Prudential Arbitrage Fund, tells us: "Rising yields in debt instruments in the past few months have made debt funds more attractive as compared to arbitrage funds, thus resulting in heavy outflows from arbitrage funds."

In addition, flight of foreign capital from India due to heated global inflation and Russia-Ukraine war have downsized the funds' performance.

The road ahead
Arbitrage funds may be getting dumped big time, but things may be improving soon.

Nemish Sheth, the associate vice-president at IDFC AMC (equity), believes that high net-worth individuals (HNIs) and foreign investors' "sharp rise in interest in stock futures" has started creating "better spreads and opportunities".

"The spreads, which fell to as low as 3.5-4 per cent, have increased to 5.5 to 6 per cent in the last couple of months, raising expectations of inflows coming back to arbitrage funds," said Sheth.

Arbitrage funds vs other short-term debt funds
In the last one year, arbitrage funds have delivered returns of 3.44 per cent, while liquid funds and overnight funds have given returns of 4.16 per cent and 4.11 per cent, respectively.

Should you invest in arbitrage funds or liquid funds?
We also did a one-year monthly rolling returns analysis. This suggests arbitrage funds' favourable tax treatment tilts the scale slightly in their favour (see the graph).

But this benefit is better for those in the higher tax brackets.

For investors in the lower tax bracket, the difference between arbitrage and liquid funds is minimal.

Tax outcome: Arbitrage fund vs liquid fund

Returns summary
Liquid fund: 6.88 per cent
Arbitrage fund: 6.04 per cent

Returns summary
Liquid fund: 4.82 per cent
Arbitrage fund: 5.13 per cent

Note: Assuming that liquid funds are taxed at the highest tax slab of 30 per cent, while the short-term tax rate for arbitrage funds is 15 per cent. Return values are the median of the rolling returns.