Arbitrage funds: Should you buy into the optimism?

Aug 19 2014, 03:21 IST
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SummaryThe last few weeks have seen a new buzz in the mutual fund space, with fund houses promoting arbitrage funds and investors lapping it up.

The last few weeks have seen a new buzz in the mutual fund space, with fund houses promoting arbitrage funds and investors lapping it up. These funds have always been in the investment basket, but never at the forefront as an investment option. Over the last three months, many fund houses have come out with NFOs of these funds; besides, existing arbitrage funds are seeing fresh inflows.

What it is

An arbitrage fund is an open-ended equity scheme that aims to generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and derivatives segment of the equity market and investing the balance, if any, in debt and money market instruments. The fund exploits arbitrage opportunities by buying stocks in the spot market and selling corresponding futures in matching positions, thereby capturing the positive spread between the prices.

If, during a month, the futures price is more than the cash price, there is a clear arbitrage opportunity. The fund manager in this case buys the stock and shorts its future. This generates a premium, which is a risk-free return. For instance, say, on July 27, you buy stock A on the cash market and at the same time sell the futures of Stock A on August 30, which has a price of R101. For the arbitrage to work, both transactions happen at the same time and you make a low-risk return.

Why the clamour

This year's budget brought to attention the advantage of investing in equity arbitrage funds. The long-term holding period of debt mutual funds has been increased from 12 to 36 months, with capital gains tax at 20% with indexation. Earlier, it was 12 months with capital gains tax at 20% with indexation, or 10%. With the holding period going up, the tax arbitrage opportunity with other fixed income investment options, such as bank fixed deposits, has come down. This is especially true of investments maturing in one year, or if lumpsum redemptions from an open-ended scheme of a debt MF is considered.

In equity arbitrage funds, the fund manager exploits the differences in prices in the cash and futures market. This enables the fund houses to declare regular dividends, which are tax-free in the hands of the investor. Fund houses have used this effectively to garner assets under management and to declare regular monthly/quarterly dividends.

Over 3-36 months, the existing schemes have generated annualised returns of over 9%. And these returns

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