Record inflow of over Rs 15,000 crore in May. What is making arbitrage mutual funds gain investors' interest?

With arbitrage mutual funds attracting the highest inflows in May, exceeding Rs 15,000 crore, and gaining increasing investor interest, market expert believes this is due to several factors, including market volatility, tax efficiency, and relative stability. Given the current high market volatility, these funds may offer a good option for investors seeking relatively low-risk opportunities to benefit from market fluctuations.

“Firstly, arbitrage funds try to benefit from volatile markets by exploiting price differences between the cash and futures markets. This allows them to generate returns without taking on significant directional market risk. Secondly, these funds are treated as equity funds for taxation purposes, which can be beneficial compared to debt funds as they are taxed at slab rates. Short-term capital gains are taxed at 20%, and long-term gains are taxed at 12.5%. Holding of anything below one year is defined as short term, while above that is long term,” Sailesh Jain, Fund Manager at Tata Asset Management shared with ETMutualFunds.

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According to Jain, the third factor is that arbitrage funds maintain a market-neutral position by simultaneously buying in the cash market and selling in the futures market, and this helps to reduce the risk compared to other types of funds.

In May, arbitrage funds received a total inflow of Rs 15,701 crore which was the highest among all hybrid funds, according to the monthly data by the Association of Mutual Funds in India (AMFI).

Further analysis of this monthly data showed that the highest inflows in May marked the second consecutive month of the highest inflows in the category. In April, these funds received an inflow of Rs 11,790 crore, which was again the highest among all hybrid funds.
RBI in its last bi-monthly policy meeting slashed the repo rate by another 50 basis points to 5.50% and a 100 basis point CRR cut. This cut in repo rate was the third consecutive rate cut by the RBI in the current calendar year and the second one in the current financial year. This marks the third consecutive cut under Governor Malhotra.
Post RBI slashing down the repo rate, market experts believe that fixed income landscape has turned even more favorable for investors and the CRR cut is a strong liquidity injection, which will further push down short-end rates and improve system-wide liquidity.
Since the last rate cut by the RBI, banks have also reduced interest rates on their fixed deposits. As the fixed deposits offer lower interest rates compared to debt mutual funds, Sagar Shinde, VP of Research at Fisdom, shared with ETMutualFunds that investors in higher tax brackets, with a 1–5-year horizon, can consider diversifying beyond FDs into mutual funds.

“Arbitrage funds can be more efficient for holding periods of one year or more, while income-plus-arbitrage funds tend to become more tax-efficient when held for over two years,” he recommended.

Now, the important thing to check is how the recent RBI rate cut and improved debt outlook will affect returns from arbitrage funds.

Sharing similar thoughts on debt funds, Jain said that the recent RBI rate cut has reshaped the debt market landscape, and the impact on arbitrage funds includes lower short-term interest rates, improved liquidity, and debt market sentiments.

Jain said that as arbitrage funds earn returns from the spread between cash and futures prices, a rate cut typically narrows this spread, as borrowing costs decline and futures premiums compress. “This could moderately reduce arbitrage opportunities, especially in a low-interest environment, but the impact is much lesser when compared to debt funds, which are directly exposed to interest rates,” he added.

Secondly, the CRR cut boosts liquidity, which can enhance trading volumes and increase market efficiency, and higher liquidity may lead to more frequent arbitrage opportunities, albeit with tighter spreads. And lastly, while arbitrage funds are not directly exposed to interest rate risk like debt funds, rate cuts would impact debt products directly lowering their returns.

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“While Arbitrage funds are largely exposed to equities, the rate cut impact is low, hence it may yield relatively competitive returns than the comparable debt funds on post tax basis,” Jain further added.

While arbitrage funds come as an option for investors’ to park their money for a year or more and offer best after-tax returns. Another option available for parking money for short-term is liquid funds.

Liquid funds have very low risk, carry credit and interest rate risk but arbitrage funds have no risk as 100% is hedged. The returns offered by liquid funds are low and those offered by arbitrage funds are moderate.

As these two options are available for parking money for short-term, Jain said that, “We continue to remain optimistic on Arbitrage fund, with increased activity in the market may continue to provide continued opportunity for the arbitrage funds to generate relatively competitive returns than the comparable debt funds on a post-tax basis.”

Arbitrage funds look for arbitrage opportunities available between the cash and derivatives markets. In other words, the fund managers in these schemes look for the price difference that they can exploit between the cash and derivatives markets. They may also invest in debt securities and equities if there are no arbitrage opportunities available in the market.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)

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