One of the most important aspects to consider when dealing with arbitrage funds is their tax treatment.
Arbitrage funds are gaining traction among investors as effective vehicles to park surplus funds, supported by a buoyant equity market that continues to offer enhanced deployment opportunities, say experts.
Arbitrage funds belong to the hybrid category. They buy shares in the cash market and sell them in the futures market. At expiry, they reverse their positions to pocket the price difference. In the long term, the returns these funds generate typically track the yields on instruments in the money market.
Arbitrage funds are categorised as equity funds for taxation purposes as they allocate a minimum of 65 percent of their assets to equities, offering the potential for better returns than savings bank interest.
Arbitrage funds reduce risk by completely hedging equity exposure, which separates them from liquid funds by the absence of credit risk.
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Strong demand
On average, Arbitrage funds have given a return of 7.07 percent over the past 12 months and 6.51 percent over the past three years, Value Research data shows.
While this mutual fund category saw outflows in March, industry experts say net Flows into arbitrage funds were positive due to attractive spreads in April.
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Arbitrage roll-over spreads averaged around 63–64 basis points (bps) in April, with levels hovering near 60 bps most of the time. These attractive spreads contributed to positive net flows into the category. Fresh arbitrage opportunities are offering spreads around 55 bps (as on April 30).
“Looking ahead, the sustainability of arbitrage spreads will depend on market inflows, short-term interest rate movements, and overall market direction — with bullish sentiment typically supporting higher spreads and vice versa,” said Chintan Haria, principal–investment strategy, ICICI Prudential Mutual Fund.
Opportunities in arbitrage funds
Valuation concerns, geopolitical tensions and tariff wars have led to a correction in markets and a consequent reduction in participation by retail investors and high net-worth individuals (HNIs) in the stock futures segment.
This has resulted in reduced arbitrage spreads.
“We need a sustained upward movement in equity markets and more participants willing to go long on stock futures for the spreads to improve,” said Deepak Gupta, fund manager, Invesco Mutual Fund.
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He said arbitrage funds remain lucrative for investors willing to wait more than a year, as the tax incidence reduces significantly after the period.
“Additionally, investors who want to avoid duration risk on their debt investments can consider the arbitrage category,” he said.
What should investors do?
Arbitrage funds can be a smart addition to a portfolio. They offer relatively stable returns with lower risk, as these funds follow a market-neutral strategy. They generate returns regardless of market direction by capitalising on price differences.
These funds can serve as a viable alternative to traditional debt instruments, typically delivering returns in the 6.5 percent to 7.5 percent range.
One of the most important aspects to consider when dealing with arbitrage funds is their tax treatment.
“Unlike most debt instruments, which were taxed at your income slab rate. Arbitrage funds are taxed under the head of equity gains. That means long-term capital gains are taxed at 12.5 percent. For someone in the highest tax bracket, earning over Rs 12 lakh a year, this can be the best tax-saving product,” said Chethan Shenoy, executive director & head-product & research, Anand Rathi Wealth Limited.
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That said, arbitrage funds may not be ideal for everyone.
For investors in lower tax brackets, particularly those with annual incomes below Rs 12 lakh, other options like target maturity funds or traditional debt mutual funds may offer better value. In such cases, the tax advantage of arbitrage funds is relatively limited.
“Additionally, it is recommended for investors to cap their allocation to around 15–20 percent of their overall portfolio as their returns are conservative. A mix of equity and debt or arbitrage will be a wise asset allocation strategy to have,” Shenoy said.