An analysis of mutual fund performance over the past 12 months by CRISIL Research, India’s largest integrated and independent research house, reveals that arbitrage funds have generated the highest post-tax returns and outperformed all other mutual fund categories.

During the period 01 July, 2011 to 30 June, 2012, arbitrage funds gave a post-tax return of 9% compared to 8.4% for debt funds and negative 4.1% for equity funds. The analysis is based on the performance of eight arbitrage funds.

Arbitrage funds are a niche category which tries to take advantage of the price difference between cash and futures (derivatives) markets to generate returns. The ability of these funds to generate higher returns depends on the volatility in equity markets — the higher the better. Over the past one year, the equity markets have been volatile thereby creating opportunities for such funds to generate high returns.

As arbitrage funds predominantly invest in equities, they are treated at par with other equity funds for taxtreatment.Risk-averse investors who shy away from equities owing to high volatility can look at arbitrage funds as a relatively safer option within equities. According to Jiju Vidyadharan, Director - Funds and Fixed Income Research, “Arbitrage funds have a low risk-return trade-off and generate moderate returns.
Arbitrage opportunities to be exploited depend upon the extent of volatility in the equity market - the higher the volatility, the higher the returns. During the volatile 2006-2008 period, arbitrage funds gave healthy post-tax returns of 8-9%.”

The category has also provided higher returns in the short-term and can act as an alternative to short-term debt funds. During the past three and six months, arbitrage funds gave post-tax returns of 2.38% and 4.28%,
respectively vis-à-vis 1.84% and 3.5% for debt-short funds and 1.99% and 3.74% for ultra-short term funds.

“The dividend option of arbitrage funds is further lucrative as dividends are tax free for equity funds, while short maturity debt funds are subject to a dividend distribution tax” adds Mr. Vidyadharan. Arbitrage funds have been in existence in India for the past eight years. Erstwhile Benchmark Mutual Fund (now Goldman Sachs Mutual Fund) was the first mutual fund to launch an arbitrage fund. Today, there are 15 funds in India which use arbitrage strategies to generate returns. However, it is important that investors carry out basic due diligence before selecting an arbitrage fund.

To begin with, investors need to differentiate between pure arbitrage and arbitrage plus funds. In the former, the equity component is completely hedged while the latter can take unhedged positions and thus carry a higher risk. Only eight of the 15 arbitrage funds can be considered as pure arbitrage funds. Investors must also ensure that their arbitrage funds maintain an equity exposure of at least 65% to enjoy the tax benefits of an equity fund. While choosing arbitrage funds, one also needs to look at the exit loads which range from 0.25% to 1% for exits varying from 7 days to 1 year.