Can Arbitrage Funds give negative returns?

Many of us explore arbitrage funds because of their tax advantage over debt mutual funds. However, can arbitrage funds give negative returns? YES, they can!!

Investors who explore arbitrage funds are aware about the fact that the tax treatment of these funds is similar to that of equity. For holdings of less than a year, the Short-Term Capital Gains (STCG) tax rate is 15%, while for holdings exceeding a year, the Long-Term Capital Gains (LTCG) tax rate is 10% (applicable on gains exceeding Rs.1 Lakh of STCG).

As a result, many people are choosing to invest in arbitrage funds instead of traditional debt instruments like Bank FDs or Debt Mutual Funds. It is worth mentioning that currently debt mutual funds are taxed in a similar manner to Bank FDs. This means that the tax treatment will vary based on your tax bracket, regardless of whether you hold the investment for a short or long period of time.

What are arbitrage funds?

According to the SEBI definition, an arbitrage fund is a fund that holds a minimum of 65% of our funds in equity or equity-related instruments (usually to qualify as an equity fund for tax purposes).

After analyzing the portfolio of the Kotak Arbitrage Fund, which was selected for its largest AUM, it is evident that the fund has 78% of its exposure in cash and future markets. The remaining 22% is divided among its own money market fund, liquid fund, savings fund, and a certificate of deposit of A1+ rated debt paper (0.19%).

The fund’s debt portion is allocated to its own debt mutual funds rather than directly holding bonds or securities, resulting in higher costs. Unfortunately, this fact is often overlooked. The fund holds approximately 0.19% in commercial paper, while the remaining debt portion is invested in its own debt mutual funds. This strategy is not unique to the Kotak Arbitrage Fund; it is a common practice among many arbitrage funds.

After closely analyzing the definition, it is clear that there is ambiguity in the definition of the debt portion. As a result, if you are not familiar with the specific investments within the fund’s debt portion, such as low-rated bonds or securities, investing in the debt portion of arbitrage funds could potentially be risky for you.

Investing in arbitrage funds without understanding where the fund’s debt part is allocated poses an initial risk. Let us now delve into comprehending the arbitrage position of these funds in a simpler manner.

Arbitrage funds can be compared to financial detectives. Fund managers actively search for differences in prices between two markets and use this information to make investment decisions. To better understand this idea, let’s look at the following example.

There are essentially two types of markets in the equity market: the cash market and the futures market.

Cash Market – If you want to buy a kilogram of bananas for Rs.50, you pay the amount and immediately receive the bananas. This quick transaction is known as the cash market, also called the equity market.

Future Market – The market settlement, as indicated by its name, will be finalized at a later time. In the futures market, the price for the same commodity (such as bananas in this instance) used to vary from the spot market.

Let’s consider that the current price of bananas per kilogram stands at Rs.50, known as the spot price. Looking ahead, the price of a one-month future in the market is Rs.52. Consequently, the variance between the spot and future market prices amounts to Rs.2.

Let’s consider the scenario where Mr. X bought one kilogram of bananas for Rs. 50 in the cash market and then sold the same quantity in the futures market for Rs. 52.

Following one month, in the event that the cost of bananas rises to Rs.55, the profit from the spot market deal amounts to Rs.5. Conversely, the loss incurred from the future market transaction is Rs.3. Consequently, the overall profit from the aforementioned transaction of purchasing from the spot market and selling in the future market is Rs.2.

Assuming that a month later, the scenario is reversed from the explanation provided earlier. In this case, the price of bananas in the spot market is Rs. 47. The loss incurred from holding the bananas for a month in the cash market amounts to Rs. 3. On the other hand, the profit gained from the future market is Rs. 5. Consequently, the net profit resulting from the transaction of purchasing from the spot market and selling in the future market is Rs. 2.

Arbitrage fund managers serve as detectives, pinpointing price differences between the equity spot market and the equity future market, referred to as a spread. A positive spread usually signifies a higher future price compared to the spot price, but this is not always the scenario. There are times when the spread can even turn negative.

In the event that the trend shifts and the future price falls below the spot market price, a negative spread may lead to the funds producing negative returns for a limited period of time, typically in months rather than years. Without a favorable arbitrage opportunity, the fund manager might halt new investments from investors. Otherwise, the fund will be compelled to generate negative returns for a short duration due to the negative spread.

Below are the different factors that can lead to negative returns in arbitrage funds.

1. In periods of bearish or range-bound markets, the likelihood of finding arbitrage opportunities diminishes. Consequently, an arbitrage fund may be compelled to allocate its investments towards debt instruments or maintain a cash position in such circumstances.
2. Furthermore, in times of bearish market sentiment, futures contracts might be valued at a lower price (at a discounted rate) in comparison to the cash market, leading to negative spreads.
3. As the assets under management (AUMs) of arbitrage funds rise, a greater amount of capital begins to seek out arbitrage opportunities. As a result, the price spreads frequently diminish.
4. When interest rates decrease, the future price of a stock is determined by adding the spot price to the risk-free rate. As a result, a decline in interest rates causes the futures price for the stock to decrease, leading to smaller spreads and fewer opportunities for arbitrage. With the decrease in costs, there is an increase in the involvement of foreign institutional investors (FIIs) in Indian equity arbitrage trades. This, in turn, contributes to the overall reduction in arbitrage spreads in the market.

Therefore, it is a misconception to believe that investing in arbitrage funds will always result in positive returns. While there may be periods of negative returns that last for a few months, relying on systematic withdrawal can have a significant impact. Additionally, frequent occurrences of negative returns over a few weeks or months can lead to a substantial sequence of returns risk if you depend on these funds for systematic withdrawal.

Can we invest in Arbitrage Funds?

# If you are more concerned with taxation than safety, you may explore.

# Do not consider investing in arbitrage funds if your short-term goals are less than a year away or if they are of utmost importance.

# Arbitrage funds should not be considered replacements for Overnight Funds, Liquid Funds, Ultra Short Term Funds, and Money Market Funds.

# If you are aware of where the debt portion of the arbitrage funds is invested and are comfortable with the associated risk, then you can proceed accordingly.

# It is essential to understand how they work before making any investments. Do not invest solely based on tax advantages or previous performance.

# Please keep in mind that according to SEBI, this falls under the category of a hybrid fund. The risk and expenses associated with arbitrage funds can be significant if the fund manager decides to invest in different debt funds or takes on excessive risk by holding low-rated bonds or debt securities.

Sharing the latest updates on the returns of all arbitrage funds, it is evident that there has been a negative trend over the past week. This serves as a reminder for individuals who firmly believe that arbitrage funds consistently yield positive returns.

In conclusion, it is important to understand that every product or asset comes with its own set of pros and cons. It is essential to carefully consider the risks involved before making any decisions.