Arbitrage funds saw the highest inflows among Hybrid Funds in FY24: Here’s what attracting investors to this scheme

Arbitrage funds were the pick among hybrid schemes in FY24, attracting inflows of Rs 90,846.11 crore, according to AMFI data. Multi-asset allocation funds came a distant second at Rs 33,053.65 crore.

Arbitrage funds, which take advantage of the differential between futures and spot prices, are gaining popularity with wealthy investors and even institutions, as they offer better returns compared to liquid funds with minimal risk.

An investor parking short-term or emergency money in liquid funds like savings accounts typically receives a 3-4 percent annual return, whereas arbitrage funds provide an annualized return of 7.5 percent.

On the higher side, arbitrage funds run by SBI, Invesco and Kotak delivered returns ranging between 7.6-7.8 percent. On a one-year basis, the average returns of arbitrage MF schemes stood at 7.34 percent compared to 8.11 percent by the benchmark index. Despite this, one reason investors choose arbitrage funds is their low-risk proposition.

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How do arbitrage funds work? In arbitrage funds, positions are taken based on volatility and the spreads between the cash and futures market prices for a stock. The fund managers in these schemes look for price differences that they can exploit between the cash and derivatives markets by buying a given quantity of the scrip in cash and shorting the same quantity of the given scrip in futures.

For instance, the current price of Stock X might be Rs 300, but the futures may be trading at Rs 301. This would allow the manager of the arbitrage mutual fund to make a risk-free profit of Rs 1 when the futures and spot prices converge at expiry.

Volatility and Buoyancy in the Market Directly Impact Returns

Volatility in the stock market can significantly impact arbitrage funds by offering better arbitrage opportunities. However, there may be periods when such opportunities are scarce, especially when the market trends strongly in one direction.

Stock Picking in Arbitrage Funds

Sailesh Jain, fund manager at Tata Arbitrage Fund, says he is sector neutral while picking stocks in his fund.

“Stock selection relies on volatility metrics. Starting from a macro perspective, I assess global sector trends, domestic news, market behavior, and then prioritize stocks with the highest spreads.”

He elaborates, “Market dynamics constantly change, impacting spreads between cash and futures. Monitoring spreads is a continuous, dynamic process. Today, I might favor the banking sector for deployment, but this can swiftly shift to another sector based on evolving market conditions and changing spreads on day to day basis.”

Jain stresses, “There’s no fixed timeframe for sector allocation. If I am deploying, I am extremely sector agnostic. The Oonly point is that my sector selection should be right for volatility perspective. If the sector is volatile, it is where I make money.”

Why Are They Gaining Popularity?

Arbitrage funds are gaining popularity due to several factors such as higher returns, a favorable tax structure, uncertainty in interest rates, and a buoyant equity market. These aspects particularly attract High Net Worth Individuals (HNIs) to opt for arbitrage funds.

“The objective of investing in an arbitrage fund is to typically achieve linear returns without facing drawdown and downgrade risks. There is also benefit from equity taxation advantages. This makes it appealing to investors,” explained Jain.

Performance of Arbitrage Funds and Elections

“Despite significant AUM inflows into arbitrage funds, the spreads have remained healthy, indicating strong returns. I haven’t seen this trend in 15 years, where large AUM holdings in arbitrage funds have maintained such intact spreads,” noted Jain.

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Jain pointed out that with upcoming elections and expectations of the current ruling party’s continuity, there’s confidence in market stability.

“This implies that if market trends persist, stock prices and spreads may also remain stable. So that gives me the fact that next three months also looks okay for the Arbitrage fund. As I said, volatility is very critical for enhancing the return,” Jain stated.

What Makes Arbitrage Funds Superior?

Arbitrage funds are taxed similarly to equity schemes, qualifying for a long-term capital gains tax of 10 percent if investments are held for over a year. Short-term capital gains tax of 15 percent applies if investments are held for less than a year. In contrast, liquid funds like savings funds are taxed at the highest marginal tax rates applicable to HNIs.

Evaluating Fund Performance

Jain emphasized the importance of averaging returns over three months to gauge fund viability. While monthly returns may fluctuate, maintaining a consistently higher average return than liquid funds is crucial for sustained viability.

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