Arbitrage funds in demand amid low rates

Ever since the crisis in the non-banking financial companies (NBFC) space triggered by the collapse of IL&FS, the contagion has spread to debt mutual funds (MF). The over-leveraged companies in the telecom, etc., have only exacerbated the situation for the debt market and a slew of defaults have rattled the markets. The chaos were further worsened by Franklin Templeton closing six of its schemes in April this year adding to the woes of debt scheme investors. The pandemic burdened the corporates on their debt servicing due to the extended lockdowns and the subsequent disruptions in trade.

The liquidity infused by RBI directly by way of monetary policy, indirectly through availability of various instruments and the govt. announcement of moratorium of loans has not only eased the situation, but also enhanced the overall quality of the instruments. But due to the soft interest rate scenario remaining for the foreseeable future, investors with limited risk capacity are constrained to earn better returns on their investments without exploring higher risk.

Sticking to bank deposits is not turning into an attractive option with the lowered interest rates. This is where the arbitrage funds play a crucial role for these low-risk investors. These funds try to gain from the opportunity provided between the difference in cash and future markets. The mispricing between these two markets i.e. spot and future markets are exploited to generate returns to the investors. The returns are comparable to that of the liquid funds, which have similar returns to that of the bank deposits, making them treated as quasi-debt funds.

As the prices of the stocks vary and fluctuate, the fund returns of these funds are volatile. As equity assets are marked to market, the funds could deliver even negative returns over very short periods of time. But these funds are reasonably liquid when compared with other debt funds and on par with the liquid funds.

So, these funds wouldn't face the recent predicament on which a fund house closed its funds for public. In general, these funds invest a minimum of 65 per cent in equity and related instruments (derivatives), about 20 per cent in debt instruments and the rest in fixed deposits. The debt portion is usually used for redemption requests and the debt portion acts as a hedge.

Very rarely the arbitrage positions are moved for redemptions to reduce adverse impact on the fund value. The majority equity and related instruments in their portfolio make them treated at par with equity taxation. Thus, investing in these funds will make an efficient post-tax option than that of the interest earned deposits. The short-term taxation of these funds are at 15 per cent, while that of the interest earned by the highest tax bracket is over 30 per cent putting them fairly advantageous in the short term. Of course, the cost of returns i.e. the fund management costs, are similar to that of the debt funds around one percent, relatively lower than those of the equity funds, but higher than an average liquid fund.

The average liquid fund would cost about a quarter of the cost of an average arbitrage fund. The other biggest hurdle is the exit load which range from 0.25 to 0.5 percent up to one month from the investment and mostly nil thereafter. These funds are again not of long-term in nature to be invested though they end up giving a debt-kind of returns with equity taxation. An exposure not exceeding 10 per cent of the portfolio does wonders to the portfolio where liquidity is important but looking to make an additional return from the existing cash which also proves an efficient tax avenue.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)