Arbitrage funds have recently gained traction among investors as attractive alternatives for parking surplus funds. These funds have seen growing popularity due to the buoyant equity market that provides enhanced deployment opportunities. Experts have identified them as ideal vehicles for conservative investors seeking relatively stable returns with lower risk.

What Are Arbitrage Funds?

Arbitrage funds fall under the hybrid mutual fund category. The fundamental concept behind arbitrage funds is their ability to take advantage of price differences between the cash market (spot market) and the futures market. The funds purchase shares in the cash market and simultaneously sell them in the futures market. At expiry, they reverse these positions, pocketing the price difference. This strategy is designed to capitalize on short-term inefficiencies in the market.

Though these funds are categorized as equity funds for taxation purposes, they allocate a minimum of 65 percent of their assets to equities. This equity exposure allows them to offer potentially better returns than savings bank interest, while also providing capital gains tax benefits for investors.

Risk and Return Profile

Unlike other equity-oriented funds, arbitrage funds aim to reduce risk by completely hedging equity exposure. This is achieved through a strategy that ensures limited exposure to equity market fluctuations. As such, they are distinct from liquid funds, which can carry credit risks.

Historically, arbitrage funds have delivered consistent returns, with an average return of 7.07 percent over the past year, and 6.51 percent over the last three years, according to Value Research data. These returns typically track the yields of money market instruments and provide a safer alternative compared to direct equity investments.

Recent Performance and Flow Trends

Despite some outflows from arbitrage funds in March, experts note that the fund category experienced positive net inflows in April. This was driven by attractive arbitrage spreads that averaged around 63-64 basis points (bps) in April. These spreads, which represent the difference in prices between the cash and futures markets, contributed to the sustained interest from investors.

Factors Influencing Arbitrage Spreads

The sustainability of these arbitrage spreads is contingent on several factors, including market inflows, short-term interest rate movements, and the overall market sentiment. According to Chintan Haria, Principal–Investment Strategy at ICICI Prudential Mutual Fund, bullish sentiment in the market typically supports higher arbitrage spreads, and vice versa.

However, geopolitical tensions, tariff wars, and valuation concerns have recently led to a market correction. These factors have led to reduced participation by retail investors and high-net-worth individuals (HNIs) in the stock futures segment, which has consequently lowered arbitrage spreads.

Tax Benefits of Arbitrage Funds

One of the key reasons for the rising appeal of arbitrage funds is their favorable tax treatment. Unlike traditional debt instruments, which are taxed according to the investor's income slab rate, arbitrage funds fall under equity taxation. This means that long-term capital gains (LTCG) from arbitrage funds are taxed at just 12.5 percent, a significant tax-saving benefit for higher-income investors.

For those in the highest tax bracket, arbitrage funds can be a tax-efficient investment choice, especially if held for over a year. This makes them particularly attractive for investors earning above Rs 12 lakh annually.

Who Should Invest in Arbitrage Funds?

Arbitrage funds are well-suited for investors seeking stable returns with a relatively lower risk compared to direct equity investments. They offer the advantage of a market-neutral strategy, which helps mitigate the risk associated with equity markets while still providing decent returns.

For investors who are particularly cautious about market volatility, arbitrage funds present a viable alternative to traditional debt instruments, such as liquid funds or fixed-income investments. The tax advantage they offer also adds to their attractiveness.

However, investors in lower tax brackets (those earning under Rs 12 lakh annually) may find better value in other debt instruments, such as target maturity funds or traditional debt mutual funds, which may be more tax-efficient for them.

Recommended Allocation in a Portfolio

It is generally advised to limit the exposure to arbitrage funds to around 15-20 percent of an overall investment portfolio. Due to their conservative nature, these funds may not offer the high returns associated with pure equity investments. As such, investors should ensure a balanced portfolio that combines equity and debt or arbitrage funds to maintain diversification and mitigate risks.

Conclusion

In conclusion, arbitrage funds have emerged as a smart investment choice for those looking for relatively stable returns with lower risks. The tax advantages, especially for high-income earners, add another layer of appeal to these funds. However, investors need to be mindful of market conditions, and it is essential to make well-informed decisions about their portfolio allocation. As always, diversification remains key to managing risk effectively.

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