Does Arbitrage funds perform well during market downturns?

Arbitrage funds

Many a times, people ask me if Arbitrage funds perform well during market downturns i.e. in bear or sideways market? This is primarily due to the fact that Arbitrage funds are not allowed to short sell and has to find arbitrage opportunities. So a logical question arises – Would there be an opportunity between cash and futures contract in a falling market?

First of all, quick definition of Arbitrage Funds – Arbitrage Funds seek returns from arbitrage opportunities between equity and derivatives and invest in debt when no arbitrage is possible. For more – Click here

Based on my experience and memory, I can tell you that at least during the 2008 crash, they did not suffer. Arbitrage opportunities are reasonably insensitive to bull or bear market. They can however give you negative returns for short periods – period less than 6 months. But for longer term periods they are likely to give returns equal to ultra short term funds.

In my experience, You should expect around 6% from these funds as the risk associated is the same as that of an ultra short term fund.

It is important to know that all funds do not follow a pure arbitrage strategy. While most of the funds are pure arbitrage funds, some also have a mandate to invest a small portion of the portfolio in buybacks, open offers, delisting, takeover bids, mergers and IPOs. This could add to the volatility of returns from these funds. So do check with your financial advisor on this aspect before going ahead with the investment.

One area these funds really shine or stand out is in terms of tax implication. Since arbitrage funds maintain an average exposure of more than 65% to equity, they are treated as equity funds. Which translates into NO long-term capital gain tax if you hold it for more than a year, and NO dividend distribution tax. In the latest Union Budget, the government increased the long-term capital gains period on debt funds or more precisely any non-equity oriented funds from 12 months to 36 months and fixed the capital gains tax at 20% with indexation. So compared to debt funds, arbitrage funds have better tax advantages. Moreover, a number of them distribute dividends, which is tax free and thus advantageous for many.


Arbitrage Mutual Funds in Financial Planning

So should be investing in Arbitrage Funds at all? Does it have a place in your portfolio?

Understand that Arbitrage funds should not be considered as substitution for equity mutual funds in any form or manner. With Arbitrage funds, you can expect to just get Debt fund like returns. If you are intending to build long-term wealth, arbitrage fund is NOT the approach you should take. Arbitrage funds, because of the inherent structure, really do not provide a lot of growth potential. 

If you are seriously thinking to profit from favorable interest rate movementschoose Long Term debt funds (rather than arbitrage funds). 

Arbitrage funds are really not that liquid and redemption might take a bit of time (my experience is that it take as much time as a regular equity fund takes). Therefore, do think about this aspect before you decide to invest in it

As the asset under management (AUM) for arbitrage fund increases, the possibility of arbitrage opportunities are going to decrease and also the returns for arbitrage funds will come down. 

Arbitrage funds is good alternative for parking short term funds. If you are looking to invest your funds for 1 Year –3 Years, then you can think about arbitrage funds. Again, the key aspect of Arbitrage fund is not the returns they offer but Favorable Tax Treatment that they receive. Your income tax slab will also play a crucial role.  Please refer to this chart to get an idea as to how Arbitrage funds stack against various parameters.

Arbitrage funds financial Planning


For instance , if you fall in 30% tax bracket and want to park your funds for 6 months. If you invest in liquid or short term funds, short term gains will be taxed at 30% (income tax slab). On the other hand, gains on arbitrage funds will be taxed only at 15%.  Further, if you invest for more than 1 year then all gains are considered as Long Term capital gains (since Arbitrage funds maintain an average exposure of more than 65% to equity) which translates into NO Capital Gains tax and NO dividend distribution tax.

Recommendation for specific Arbitrage funds:

So if you want to park some funds for short period of time, from 1-2 years, then a natural question arises which fund is good for this purpose?

I would recommend UTI Spread Fund Direct Plan Growth  Option OR Kotak Equity Arbitrage Fund Direct Plan Growth Option.

Why? Because both these funds are 100% pure arbitrage fund. The investment objective of the plan is to give Capital Appreciation and also Dividend by means of arbitrage opportunities occurring from price discrepancies between the cash and derivative market by investing mainly in Equity & Equity related securities, derivatives and the balance portion in debt securities. All Derivatives positions for the plan is going to be taken with a view to hedge the corresponding equity exposures in entirety. The scheme, by no meansis going to take a directional/unhedged position in either equity or derivative instruments.

Note: Their SID document states that they may hold short-term bond exposure (around 10- 35%) under normal circumstances when arbitrage opportunities are not available.

Read here about these funds in detail: Kotak Equity Arbitrage Fund & UTI Spread Fund

Disclaimer: I am not your financial advisor. Also, I am not SEBI Registered Investment Adviser. I write articles to share my opinion and experiences of managing money. The information and services may contain errors, problems or other limitations so I request you to contact your Financial advisor, CA or legal advisor for professional advice before making any financial decision. All views and opinions shared here are purely individual opinions. If you have any questions or concerns regarding this post then please contact me and let me know.


Posted in Arbitrage funds, Financial Planning, Investing and tagged CA, financial Advisor.