This price differential is the spread—the primary source of return for arbitrage funds. It is the shrinking of these spreads that handicapped arbitrage funds for most of 2022. Specifically, the weakness in equity markets led to a drying up of spreads. Arbitrage funds fetched a measly 3.9% return for the entire year, even as liquid funds delivered 4.72%. As the return profile deteriorated, investors pulled out in droves. The category witnessed heavy outflows, with assets falling from Rs.1 lakh crore to Rs.75,000 crore.
Investors chose to park surplus inliquid funds, which were better positioned to quickly capture the rising yield as the central bank hiked interest rates. Arbitrage funds captured these rising yields with some lag. However, fortunes of arbitrage funds have changed in the past three months. These have clocked 1.7% returns over the past three months, even as liquid funds fetched 1.57%. The initial recovery in equity markets in November and the subsequent range-bound volatility have helped funds rack up better spreads.
The lesser money chasing arbitrage opportunities after the investor exodus of 2022 also helped these funds capture available spreads easily. Arbitrage funds have reported to have captured a meaty spread in excess of 7.5% heading into the March expiry. Bhavesh Jain, Fund Manager, Edelweiss AMC, observes, “Arbitrage funds continue to earn healthy rollover spreads. If the market recovery picks up again, spreads will improve further.” Besides, arbitrage funds are benefiting from higher yields in their fixed income allocation. With interest rates inching up since last year, the prevailing yield to maturity for arbitrage funds’ bond allocation has also improved to a healthy 7%. Around 25-30% of portfolio of arbitrage funds is fetching this higher YTM. So does this signal a turnaround for arbitrage funds? Will it offer a compelling enough alternative to liquid funds? Arbitrage funds are often used interchangeably or as a proxy for liquid funds.
Arbitrage funds have lost out to liquid funds in recent past
Predictability of returns in arbitrage funds is lower than in liquid funds
Some advisers even recommend arbitrage funds as a better vehicle for parking temporary surplus, or for use as a source fund for transferring regular STP contribution into pure equity funds. This is because of their tax advantage over liquid funds. These are taxed as equity funds, with gains realised after a year of holding facing only 10% tax. If sold within a year, gains are taxed at 15%. Comparatively, gains in liquid funds are taxed at 20% after indexation when sold after three years. Any gains realised within three years are added to the taxpayer’s income to be taxed at the slab rate. This differential in taxation makes arbitrage funds more tax-efficient.
This is why some favour arbitrage funds even though liquid funds are offering the same YTM of around 7%. Jain asserts, “Both liquid and arbitrage funds are offering similar returns today, but the latter retain an edge in post-tax return.” However, the predictability of returns is lower in arbitrage funds while returns from liquid funds can be fairly stable. Arbitrage opportunities are known to ebb and flow, coming in bursts. The spreads keep changing depending on evolving market volatility and direction. The amount of money chasing arbitrage opportunities also influences outcomes.
Returns from arbitrage funds can climb high for a few months and remain subdued in the remaining months. For this reason, many still prefer the relative calm of short term debt funds for parking short term money. Amol Joshi, Founder, PlanRupee Investment Services, insists there is no compelling need to replace the latter with arbitrage funds. “We prefer liquid or ultra short term debt funds to keep things simple. These give a predictable return, which is not possible with arbitrage funds.” Besides, arbitrage funds incur higher expenses than liquid funds. On average, direct plans of liquid funds have an expense ratio of 0.19%, while arbitrage funds charge 0.37%. Investors keen to make the most of these funds should hold for at least one year, to enjoy beneficial taxation.
