Why are arbitrage funds growing in popularity?

Arbitrage funds have been drawing sizable investor attention in recent months.

Typically, investors keep their short-term or emergency money in liquid funds, but arbitrage funds have witnessed high net inflows - Rs 91,114 crore - in the first 11 months of FY24. In fact, between December 2023 and February 2024 alone, these funds saw net inflows of around Rs 32,761 crore.

Higher returns, favourable tax structure, interest rate uncertainty and a buoyant equity market are some of the reasons why investors, especially the high-ballers, are opting for arbitrage funds. Bhavesh Jain, Fund Manager, Hybrid & Solutions at Edelweiss Mutual Fund, says, "We have seen a lot of high-net-worth individuals (HNIs) rolling over contracts as they expect the market to rally further. We have (also) seen the money from corporate treasuries, promoters and family offices that used to move into liquid funds have started coming into the arbitrage funds."

What are arbitrage funds?

Arbitrage funds are mutual funds that profit from stock price differences. Let's say Stock A is priced at Rs 500 on the Bombay Stock Exchange (BSE) and Rs 505 on the National Stock Exchange (NSE). An arbitrage fund can buy the stock from the BSE and sell it at a higher price on the NSE for a Rs 5 profit.

Similarly, there may be a price difference between its current and future prices too. For instance, the current price of Stock A might be Rs 200, but the futures market has it at Rs 210. This would allow 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.

Reasons for growing popularity

1. Superior returns: Over the last 12 months, an average arbitrage fund has delivered 7.33 per cent returns compared to liquid funds' 7.07 per cent. On closer inspection, 18 of the 25 arbitrage funds yielded more than 8 per cent returns, with 8.46 per cent being the highest in the category. On the other hand, most liquid funds - 23 out of 39 schemes, to be precise - have given returns in the range of 7.3-7.4 per cent in the last year.

2. Efficient taxation: Arbitrage funds are more tax-friendly than liquid funds because they are treated like equity-oriented funds. For the uninitiated, investors of equity-oriented funds pay a 15 per cent tax on the gains if they exit the fund within 12 months. If they hold the fund longer than a year, there's a 10 per cent tax on gains - and that too if they exceed Rs 1 lakh in a financial year.

In comparison, debt funds, which include liquid funds, are taxed at the slab rate of that particular investor's annual income, irrespective of the holding period. So, if someone is in the highest tax bracket (30 per cent), they will have to pay 30 per cent tax on the gains made from liquid funds.

3. Conducive market conditions: Arbitrage funds benefit from cash-future spreads. Spreads are the price difference between the cash price of a stock and the future market price. So, when the markets are in a positive zone or during a high activity period (as they generally were in the last financial year), leverage positions increase, and so do the spreads. This allows an arbitrage fund manager to buy in the spot market and sell the future contract for a profit.

Our take

Arbitrage funds are usually suitable for three months to a year. However, we believe liquid funds, which have a similar risk-return payoff, are a better alternative for most investors with such a time frame. While the risk of incurring a loss in arbitrage funds over the said period is low, they do not guarantee returns or safety of capital.

That said, arbitrage funds may appeal to those in the highest tax bracket, given the preferential tax treatment of these funds.

Also read: Understanding solution-oriented funds and their exit load