Arbitrage Funds and Avenues
(This
is for information purposes only. This should not be construed as a
recommendation or investment advice even though the author is a CFA Charterholder. Please consult your financial
adviser before taking any investment decision. Safe to assume the author has a vested
interest in stocks / investments discussed if any.)
A popular perception among investors is arbitrage funds are risk-free. In actual practice, it is not so.
In an arbitrage, investors and money managers try to exploit mispricing in two different markets and make small amounts of money at very frequent intervals.
For example, if a stock is quoting at different prices in two exchanges, an investor in theory can buy where it is priced lower and simultaneously sell in another stock exchange where it is priced higher, making small profit with minimal risk in the process.
Arbitrage mutual funds in India try to encash differences between cash and derivatives market.
They buy securities (long position) in cash market and simultaneously sell them (short position) in derivatives market -- whenever there are differences in prices of securities in cash and derivatives (futures and options or F&O) market.
Put differently, the long position is hedged against the short position, with minimal risk.
As they invest both in equity and debt, arbitrage funds are hybrid funds.
Hybrid schemes invest in a blend of asset classes, like, equity, debt, commodities like gold and silver, REITs or real estate investment trusts.
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1. SEBI definition
India's capital market regulator SEBI or Securities and Exchange Board of India defines an arbitrage fund as:
Type of scheme: an open-end scheme investing in arbitrage opportunities
Scheme Characteristics: scheme following arbitrage strategy, with a minimum investment of 65 per cent of total assets in equity and equity-related instruments
The
above SEBI definition entails an arbitrage fund to invest at
least 65 per cent of total assets in equity and equity-related instruments.
2. Arbitrage fund asset mix
Typically, the asset allocation of an arbitrage is as follows:
1. Equity and equity related instruments including derivatives: A minimum of 65 per cent and a maximum of 90 per cent of total assets.
2. Debt and money market instruments including margin money deployed in derivatives transactions: A minimum of 10 per cent and a maximum of 35 per cent of total assets.
3. Expense ratio
Expense ratios are an important consideration while selecting arbitrage funds, as they tend to provide lower returns compared to equity-oriented funds.
The expense ratio range for direct plans of arbitrage funds is 0.21-0.44 per cent. There are a total of 27 arbitrage funds.
4. Exit load
Almost all the arbitrages have exit loads. The normal range is 0.10-1.00 per cent if redemeed within 15 to 30 days of investment, as per data from Value Research.
It is better to check the scheme information document (SID) of respective arbitrage fund to know more about expense ratios, exit loads, risks and other details.
5. Benchmark index
Nifty 50 Arbitrage TRI is the benchmark index for all arbitrage funds. Factsheet and methodology document of the index can be accessed here and here.
NSE Indices launched the index on 08Jul2016, with a based date of 01Apr2010. The weights of index constituents as on 30Jun2024 are:
Nifty 50 index futures (near month): 65%
1-month MIBOR: 30%
Cash: 5%
6. Category total assets
As on 30Jun2024, total assets of the mutual fund category of 'arbitrage' funds is Rs 1.80 lakh crore, with 27 schemes. The asset growth has been rapid and more pronounced since Mar2023, when Government of India withdrew indexation benefits on long term capital gains of debt mutual funds.
As the tax treatment is favourable to arbitrage funds, investors have been flocking to arbitrage funds in recent quarters. The absolute growth in AUM is 167 per cent between Mar2023 and Jun2024, while absolute growth in the past three years was just 90 per cent (AUM fell by 36 per cent between Sep2021 and Mar2023).
Table 1 showing quarterly growth of AUM in the past three years >
7. Calendar year returns and comparables
The following table 2 encapsulates calendar year-end AUM, calendar year returns of arbitrage funds (regular plans with growth option) and how the returns compare with call money rates and Nifty 50 returns.
Returns from arbitrage funds are closer to call money rates, rather than to Nifty 50 returns.
8. Quarterly returns and AUM
The following table 3 delineates quarter AUM and quarterly returns for the past three years from Jun2021 to Jun2024:
9.Tax treatment
Though
they are treated as equity oriented funds for the purpose of short-term capital gain (STCG) and long-term capital gain (LTCG) taxation, their returns are not related to equity market returns.
As per the changes made in Union Budget 2024-25 presented yesterday, the STCG tax on arbitrage funds is 20 per cent and LTCG tax is 12.5 per cent (excluding health & education cess of 4 per cent) -- both tax rates are effective from FY 2024-25 onwards. The proposals include increasing the exemption limit for LTCG on equities and equity mutual funds to Rs 125,000 from FY 2024-25 onwards (earlier exemption limit was Rs 100,000).
Prior to 23Jul2024, STCG was taxed at 15 per cent and LTCG at 10 per cent (excluding health & education cess of 4 per cent).
The author has no tax expertise, this is just educational purposes. Readers must consult their own tax / financial consultant before considering any investments.
10. Risks and opportunities
Arbitrage
funds are not risk-free. Chances of negative returns though are
minimal. Their returns are volatile from year to year and quarter to
quarter. But their return volatility is much lower compared to returns
of equity schemes.
They made losses in the past, though in shorter periods of time - see Section 12 (F) below for Best and Worst fund returns.
Loss example: A noteworthy case for substantial losses is Sundaram Arbitrage fund, whose worst period returns are as follows:
One-week worst returns: minus 3.1 per cent (Sep2018)
One-month: minus 5.1 per cent (Aug-Sep2018)
Three-month: minus 4.5 per cent (Jul-Oct2018)
One-year: minus 1.1 per cent (Sep2018-Sep2019)
As per Morningstar India, Sundaram Arbitrage fund had been in the lowest quartile in terms performance between 2017 and 2022 -- a poor reflection on the fund.
Low liquidity: Arbitrage funds are negatively impacted by low liquidity in cash and futures markets.
When
will arbitrage funds make money or under what circumstances market
presents arbitrage opportunities for managers -- during bull market or
bear market; or in volatile markets?
Whenever participation in F&O market by foreign investors, high-net worth individuals and retail investors increases, arbitrage opportunities in market tend to go up.
During times of higher volatility with prices going and up down intra-day, enhanced arbitrage opportunities exist for fund managers.
It would be in the interest of potential investors to assess whether a particular arbitrage fund is exposed to credit risk -- meaning we need to check the debt and money market instruments held by the funds.
Also, we need to check the average maturity of the portfolio, so that the fund is not exposed to interest rate risk.
It is likely higher the AUM, the higher the opportunity for money mangers.
Arbitrage opportunities also depend on the number of stocks available in the F&O derivatives market in India. As of now, there are 181 individual stocks available in F&O as per National Stock Exchange of India Ltd data.
These are in addition to derivatives contracts available on five Nifty indices, namely, Nifty 50, Nifty Bank, Nifty Financial Services, Nifty Midcap Select and Nifty Next 50.
There are cases when the the spread between cash and futures market may come down due to market conditions.
For arbitrage funds, high liquidity is most important for selling stocks or buying them. Likewise, high liquidity is key for selling and buying futures contracts.
The nature of arbitrage funds is such that they need to trade a lot and tend to have high turnover of the portfolio.
Many
arbitrage funds hold liquid / debt mutual funds of their own fund house -- arbitrage
funds have to pay expense ratio for investing in liquid and other debt mutual funds, thus reducing
returns of the arbitrage fund.
11. Similar returns - arbitrage and liquid
As mentioned above, returns of arbitrage funds are more related to call money rates, liquid fund returns and Treasury Bill yields. Their returns tend to be similar to those of liquid funds.
The returns from arbitrage funds are not related to equity returns.
For more on the similarity of returns between arbitrage and liquid funds, see blog dated 22Apr2024.
In some years, arbitrage funds' returns tend to be in line with those from liquid funds.
Please see the following screenshots and observe the resemblance of returns between arbitrage and liquid funds >
Call money and Treasury bill yields are proxy for short-term interest rates in India.
12. Portfolio / fund comparison
Arbitrage funds hold a minimum of 65 per cent or more in equity and equity-related instruments. And the remaining will be invested in debt and money market instruments, having maturity of up to one year.
As mentioned above, arbitrage funds hold long position in stocks and simultaneous short position in derivatives market, keeping the net position neutral -- meaning the exposure to equities is practically nil (it may be added as the exposure to equities is zero, the returns from arbitrage funds are not related to stock market returns).
Let us compare five arbitrage funds, direct plans with growth option, and analyse their portfolios as on 30Jun2024. The comparison weblinks can be accessed from here and here.
The five funds compared are:
Axis Arbitrage
Edelweiss Arbitrage
Invesco India Arbitrage
Kotak Equity Arbitrage
Tata Arbitrage
A). The standard deviation range for these five funds is 0.65-0.71 per cent, indicating low risk category of these funds.
B). The three-year Sharpe ratio range is 1.2-1.6.
C). Out of the debt portion, these arbitrage funds tend to hold 10 to 20 per cent total assets in their own debt mutual funds.
For example, Kotak Equity Arbitrage fund holds 20 per cent of its total assets in its own debt mutual funds, namely, Kotak Money Market fund, Kotak Savings Fund and Kotak Liquid fund. Among the five funds compared, this is having the highest exposure to its own mutual fund units.
On the lowest side among the five, Axis Arbitrage holds 8.6 per cent of total assets in its own debt fund (namely, Axis Money Market).
As such, these arbitrage funds are exposed to the risks carried by the underlying mutual funds.
D). The AUM (assets under management) range is Rs 5,200 crore-Rs 48,000 crore.
E). The expense ratio range is 0.29-0.43 per cent and exit loads are 0.10-0.50 per cent within 15 / 30 days. All these direct plans are in existence for more than five years.
F) Best and worst period returns for these five funds: On an yearly and quarterly, these funds have not provided negative returns. However, on a one-week and one-month basis, they provided small negative returns.
Worst one-week returns range is minus 0.47 to minus 0.54 per cent, and worst one-month returns range is minus 0.04 and minus 0.21 per cent. The period was between May2020 and Jun2020, when short-term interest rates (call money rate and Treasury bill rates) collapsed following the outbreak of COVID-19 Pandemic.
The best one-year returns range is 8.0-8.4 per cent during Nov2022 to Nov2023 period.
Readers can check these parameters from the individual arbitrage funds, for which weblinks are provided above.
These are randomly-selected and are used just for real-world illustration purposes. These should not be considered as recommendations and investors should do their own diligence before considering any of them for investment.
Please see additional notes for screenshots of the five-fund comparison: returns, risk ratios, asset allocation, sector allocation and credit rating.
13. Action button
Investors have to do a basic sanity check before investing in arbitrage funds. Understanding the portfolio composition, risks, expense ratios and exit loads is important.
Prospective investors will be better off if they read the scheme documents, like, scheme information document (SID), key information memorandum (KIM), statement of additional information (SAI) and othere relevant documents, before taking investment decisions.
Arbitrage funds' returns tend to be in tandem with those of liquid funds, but they have one distinct advantage -- especially for investors who in higher tax brackets of 20 and / or 30 per cent and above.
Arbitrage funds are treated like equity mutual funds for capital gains tax purpose, whereas liquid funds are not. The former are subject to favourable taxation compared to the later.
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Additional notes and screenshots:
Screenshots of the five-fund comparison: returns, risk ratios, asset allocation, sector allocation and credit rating >
Nifty 50 and other indices returns screenshot >
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Reference shelf:
Weblinks throughout the blog
SEBI Categorization and Rationalization of Mutual Funds
A Template for Analysing a Debt Mutual Fund (see Additional Notes)
VR Arbitrage funds all
Value Research annual, quarterly and trailing returns
VR Compare five arbitrage funds
MS Compare five arbitrage funds
Mutual Fund Categories with Similar Returns
Mutual Fund Asset Class Returns (categories with Similar Returns)
SID of Kotak Equity Arbitrage fund
Arbitrage funds article 29Jun2007
Tweet / X Post thread dt 27Jul2024 - tax rate increased proposed to LTCG and STCG - Section 111A, Section 112A and Section 112
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Disclosure: I've got a vested interest in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
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