Arbitrage Funds: An alternative to Debt funds
Updated: Jun 23, 2020
Arbitrage funds are often recommended to the investors as an alternative to debt funds for parking short-term surpluses, given their tax advantage.
Is the tax-advantage is a sufficient reason to allocate funds in Arbitrage funds?
Arbitrage funds generate returns by engaging in arbitrage opportunities and taking advantage of the spread or the differential in the price of a stock in the spot market (that is the stock market) versus its price in the futures market. Most stocks generally trade at a premium in the futures market (unless the market sentiment turns very bearish) and this provides the spread.
How stock-futures arbitrage works
Suppose a fund buys the stock of company A at Rs.200 and sells company A’s stock futures at Rs.201.
The fund can continue to hold its position till the expiry of the futures contract. Alternatively, it can close the contract or roll it over to say the next month, before the expiry date.
The strategy of buying a stock in the spot market and alongside selling the stock futures (which is trading at a premium) ensures the fund’s equity exposure is fully hedged and it locks into the spread (futures price minus the spot price) right away.
Arbitrage funds, therefore, do not face the risk of stock calls going wrong like it’s with equity funds.
Arbitrage funds are treated as equity funds for taxation purposes. That is, short-term returns (less than 1 year) are taxed at 15% plus surcharge and cess, while long-term returns (1-year and above) are taxed at 10% plus surcharge and cess. Further, the 10% tax applies only on returns in excess of Rs. 1 lakh a year for an individual.
After the cess and surcharge are included, the 15% short term capital gains tax translates into 15.6% to 20.5% depending upon the income levels. Likewise, the 10% long term capital gains tax translates into 10.4% to 13.7%.
After-tax returns for the investor’s in the high tax-bracket beat shorter-term debt funds nearly all the time.
While the slightly higher returns may be tempting, those in the higher tax brackets must keep in mind the high near-term volatility too. This can be gauged from the high number of instances of negative daily returns.
Over the last 10 years, arbitrage fund daily returns were negative 31% of the time. For short-term debt funds, this happened only 1.5% of the time.
Further, arbitrage funds must invest a minimum of 65% in equity and equity-related investments. Another 15-20% must be in fixed deposits (for margin requirement) and the rest in debt/cash. It is therefore worth checking the credit quality of an arbitrage fund’s debt portfolio and the associated credit risk and duration risk.
What drives volatility and returns?
Arbitrage fund returns essentially depend on the spreads between the cash and the futures market. The spreads (which can shrink or worse still, turn negative) in turn are a function of several other factors which are ever-changing and may not be within a fund’s control. This makes the returns from arbitrage funds unpredictable and hence the volatility element.
Here are some factors that can impact the spread between the cash-futures market and so the returns from arbitrage funds:
Equity market sentiment turning bearish
Arbitrage funds do well in volatile markets (with the bullish sentiment) because that’s when profitable arbitrage opportunities are easily available.
Volatile markets also increase the ability of arbitrage funds to enhance their returns intra-month by exiting stocks where spreads have gone down and investing this money either in debt or in stocks where spreads are higher.
In periods when markets are stable/range-bound and arbitrage opportunities dry up, such funds may have to stay invested in debt or hold cash. Also when the market sentiment is bearish, futures may trade at a discount (and not a premium) to the cash market implying negative spreads. In such situations, arbitrage funds will underperform. Take March (17th to 25th) this year for instance, when the stock markets hit all-time lows. Then, the cash-futures spreads turned negative on some of these days and so did the daily returns from arbitrage funds.
Lower domestic interest rates
As interest rates fall, arbitrage returns too are likely to fall.
There are 2 reasons why this happens
Investors going long on futures (who are responsible for the premium spread) can now borrow at a lower cost and hence take larger positions with the borrowed money leading to lower premium in futures.
When interest rates come down then future debt fund return potential also comes down. But if the arbitrage spreads continue to be high, then money will move from debt funds to arbitrage funds, leading to more money chasing the same arbitrage opportunities and hence eventually leading to lower spreads and returns subsequently.
FIIs – currency hedging and borrowing costs matter
Lower INR hedging cost and borrowing cost reduce the arbitrage thresholds for FIIs, increasing their participation in the Indian equity arbitrage trades and consequently bringing down the spreads.
On the other hand, whenever the INR hedging cost or the borrowing cost of FIIs increases, their participation in the Indian arbitrage market reduces thereby allowing domestic arbitrage funds to take advantage of arbitrage opportunities.
Those in the high tax bracket who want to consider arbitrage funds for their short-term surpluses should keep all these risks in mind.
Arbitrage funds attract an exit load of mostly 0.25% or 0.5% for an exit before 30 days (15 days). Most shorter-term debt funds, on the other hand, have no exit load.
As the arbitrage fund category grows in size (if the funds perform well and/or more investor money flows in), that in itself will work towards gradually driving down their returns over time. This is because with more money chasing the existing arbitrage opportunities, spreads will eventually narrow down.
For those with an investment horizon of longer than 1 year (all tax brackets), I recommend short-term debt funds (high credit quality) given the stability and some predictability of their returns.
Here are some of the options for arbitrage funds:
1. Kotak Arbitrage Fund
Although debt holding is concentrated, most of those holdings are safe.
2. Edelweiss Arbitrage Fund
Most of the top debt holdings are safe.
Do not get swayed by the marketing done by asset management companies around arbitrage funds, it can fire back too especially when the markets are moving sideways.