Learn About Arbitrage Funds Basics and More

An arbitrage fund is classified as an equity fund for tax purposes but it is virtually a fund that mirrors debt market returns. But what exactly is an arbitrage fund? Let us look at this category of funds in detail?

How do arbitrage funds invest?

As the name suggests, an arbitrage is a mispricing opportunity which the trader tries to exploit. This is a very short term opportunity but can yield almost safe and risk-less returns to the trader. Here is how arbitrage funds actually function. Essentially arbitrage funds leverage on the interest spread between the cash and the futures market. So, what does the fund manager in an arbitrage fund do?

Effectively, the fund manager buys equity shares and sells the stock futures on those shares. So, this arbitrage is only possible where the stock is also available in futures. The premium on futures over the spot price gets locked in as assured profit till the date of expiry (which is the last Thursday of the month).

How do you realize the Profits in an arbitrage transaction?

In an arbitrage transaction, you buy in ash and sell equivalent futures. For example, if a stock has a lot size of 600 shares then you buy 600 shares in the spot market and sell 1 lot in the futures market. One way to book profits is to reverse the arbitrage transaction i.e. buy back the futures and sell the cash position, so the profit can be realized.

However, the above strategy can entail higher costs and higher tax implications. Hence, arbitrage fund manages normally adopt a slightly different strategy. On expiry or before that, the cash equity position is held on while the futures position is rolled over to the next month. The rollover premium becomes the monthly income for the fund and entire funds locked in the arbitrage are released when the total arbitrage position is liquidated.

Can you explain with an example how arbitrage works in practice?

Let us take a stock X which is quoting at a price of Rs.1,200 and has a lot size of 600 shares. It is interesting to understand how an arbitrage is actually done. Assume that Stock X quotes at Rs.1200 and its Futures are quoting at Rs.1,209. The fund manager will buy Stock X in the spot market at Rs.1,200 and sell Futures at Rs.1209. This spread of Rs.9 is the assured return to the fund. This varies for different stocks.

What does this mean in terms of returns? That translates into a return of 0.75% (9/1200) for a period of 1 month or roughly (9.38%) annualized returns. But the 9.38% returns are not earned by the fund. There are transaction costs, statutory charges and operating cost that the fund needs to bear. All this will probably wipe off 1-2% from the returns and leave the investors with an annual return of around 7.38%. is that really attractive? Remember, you must compare arbitrage funds to liquid funds and so anything above 4-5% annualized is attractive returns.

How is the tax treatment of an arbitrage fund investment?

In terms of risk profile, the arbitrage fund is akin to a debt fund because the gap between spot and futures represents one-month interest cost. As an investor, once you lock in the arbitrage, it is assured returns irrespective of whether the market goes up or down. To that extent its returns are nearly assured and it looks more like debt in terms of risk and return profile. But the bigger advantage for arbitrage funds comes from tax implications.

Arbitrage funds are treated as equity funds since 65% plus exposure is to equities. Now dividends even on equity funds are taxed as other income so there is no special benefit. However, the benefit lies in capital gains. In terms of capital gains, arbitrage funds are subject to long term capital gains tax or LTCG tax at 10% only above Rs.1 lakh per annum. On the other hand, short term capital gains or STCG is taxed at a concessional rate of 15%. This enhances the post-tax returns of arbitrage funds compared to debt funds.

Do fund managers also create Alpha in arbitrage funds?

Alpha refers to excess returns that a fund can earn over and above what the general market earns. There are 2 ways that fund managers can create alpha in arbitrage funds.

  • First is dividend arbitrage. Since futures do not earn dividends, the futures price tends to quote at a discount to the extent of dividend. If the fund manager expects that the actual dividend will be higher than historic dividend then they bet on the current spread.
  • The second way to earn alpha is to bet on market volatility. When markets become volatile, the spreads in many stocks become negative due to aggressive short selling. Fund managers can proactively unwind arbitrage position to extra returns.

How big is arbitrage fund segment in india and what are tap performers?

The arbitrage funds have a total AUM of Rs.1,15,698 crore in India as of 21-December 2021. Here is a list of major arbitrage funds in India ranked on 1-year returns.

UTI Arbitrage Fund PGIM India Arbitrage
Scheme Name NAW Direct Return 1 Year (%) Direct Return 3 Year (%) Direct Return 5 Year (%) Direct Since Launch Daily AUM (Cr.)
Edelweiss Arbitrage 16.29 4.74 5.63 6.07 6.74 6,421.82
Kotak Equity Arbitrage 31.31 4.71 5.41 5.89 7.08 24,964.29
Nippon India Arbitrage 22.58 4.70 5.54 6.08 7.15 11,540.35
Tata Arbitrage Fund 11.86 4.70 5.87   5.84 11,308.79
Birla Sun Life Arbitrage 22.52 4.68 5.39 5.85 6.99 8,711.33
Axis Arbitrage Fund 15.97 4.68 5.38 5.90 6.57 4,177.82
UTI Arbitrage Fund 29.43 4.61 5.41 5.85 6.72 5,998.62
SBI Arbitrage Fund 28.23 4.58 5.02 5.58 6.79 5,516.57
ICICI Pru Arbitrage 29.00 4.55 5.32 5.82 7.09 14,964.68
L&T Arbitrage Fund 16.09 4.52 5.45 5.93 6.56 4,782.07
BNP Paribas Arbitrage 13.41 4.52 5.47   6.07 721.95
PGIM India Arbitrage 15.64 4.44 5.10 5.64 6.30 144.33
IDFC Arbitrage Fund 27.62 4.40 5.28 5.83 6.93 5,696.81
HDFC Arbitrage Fund 15.92 4.37 5.03 5.47 6.22 7,351.16
Mirae Asset Arbitrage 10.63 4.35     4.17 441.01
Invesco India Arbitrage 26.83 4.32 5.27 5.74 6.80 804.13
Union Arbitrage 11.55 4.28     5.25 87.51
DSP Arbitrage Fund 12.36 4.22 5.28   5.58 1,827.43
Sundaram Arbitrage 10.80 4.07     4.21 85.06
LIC MF Arbitrage 11.46 4.04     4.79 26.61
Mahindra Arbitrage 10.49 3.84     3.69 29.44
ITI Arbitrage Fund 10.90 3.35     3.84 11.92
India bulls Arbitrage 15.14 3.27 4.47 5.22 6.09 10.56
JM Arbitrage Fund 27.71 3.27 3.99 4.70 6.33 49.97
BOI AXA Arbitrage Fund 11.70 2.96 4.32   4.57 16.69
Principal Arbitrage Fund 12.16 2.92 3.27 3.07 3.51 7.54

In the above table, we have considered Direct Plans as they make more sense when the returns are already quite low.