We have all heard of arbitrage funds in the mutual funds space, but have you ever wondered how these arbitrage funds actually function. Before getting into the nuances of an arbitrage fund, we need to realize that arbitrage funds are classified as equity funds but for all practical purposes they are debt funds as they leverage on the interest spread between the cash and the futures market. As the name suggests, these funds arbitrage away the spreads between the cash market and futures market and make money out of the spread. Effectively, the fund manager buys equity shares and sells the stock futures on those shares. The premium, therefore, gets locked in as an assured profit till the date of expiry (last Thursday of the month). On that day the cash equity position is held on while the futures position is rolled over to the next month. The rollover premium becomes the monthly income for the fund and entire funds locked in the arbitrage are released when the total arbitrage position is liquidated or reversed in totality.
 
Let us understand the benefits of arbitrage funds and how they fit into your portfolio scheme of things:
 

• How does the concept of arbitrage really work?

It is interesting to understand how an arbitrage is actually done. Assume that Reliance stock quotes at Rs.1200 and Reliance Sep Futures is quoting at Rs.1209. The fund manager will therefore buy the Reliance stock at Rs.1200 and sell Reliance Futures at Rs.1209. This spread is also referred to as the Cost of Carry and it becomes the assured return for the fund manager. That translates into a return of 0.75% (9/1200) for a period of 1 month or roughly (9.38%) annualized returns. But the 9.38% returns are not earned by the fund. There is a transaction cost, statutory charges and operating cost that the fund needs to bear. All this will probably wipe off 1% from the returns and leave the investors with an annual return of around 8.38%. But what is so attractive about an 8.38% net return?
 

• Arbitrage funds are all about tax implications

In terms of risk profile, the arbitrage fund is akin to a debt fund since the spread between spot and futures represents the one-month interest rates. This is because an arbitrage fund tends to operate on spread and does not assume any directional risk in the market. To that extent its returns are nearly assured, if not entirely assured. It is, therefore, more comparable with debt funds in terms of risk and return profile. That is where the big advantage comes in terms of tax implications. Arbitrage funds are treated as equity funds since they have over 65% exposure to equities. As a result dividends paid out by arbitrage funds attract DDT of just 10% and the dividends do not attract any tax at the hands of the investor. In terms of capital gains, arbitrage funds are subject to long term capital gains tax at 10% only above Rs.1 lakh per annum, while short term capital gains are taxed at a concessional rate of 15%. This raises the returns of arbitrage funds in post-tax terms vis-a-vis debt funds.
 

• If the fund manager is smart, they can create alpha through arbitrage funds

Alpha refers to excess returns that a fund can earn over and above what the general market earns. But, how do you generate alpha in an arbitrage fund? In debt funds, the scope for alpha is limited since interest rates and credit quality tends to impact all debt funds equally. However, in case of arbitrage funds there is scope for Alpha and that can be used by fund managers to earn their extra return for their fund. There are two specific cases where alpha can be drawn from arbitrage funds.

Dividend arbitrage is a popular way of gaining alpha in arbitrage funds. Since futures do not earn dividends, the futures price tends to quote at a discount to the extent of dividend. If the fund manager expects that the actual dividend will be higher than the historic dividend then he can bet on the current spread. This happened when PSUs were giving higher dividends at the behest of the government. This created an opportunity for arbitrage fund managers to bet on higher dividend and earn higher arbitrage spreads.

The second way to earn alpha is to bet on market volatility. When markets become volatile, the spreads in many stocks tend to become negative due to aggressive short selling. This is normal when the VIX goes up sharply. Fund managers can use this opportunity to proactively unwind their arbitrage position and earn additional returns due to the volatility.

Arbitrage funds are actually attractive when you add up the tax benefits. Alpha can also be extracted from arbitrage funds when the markets are very volatile. In arbitrage funds, you have a product that is smart and compelling for conservative investors. It may be time to look at arbitrage funds more seriously as a value enhancer.
 
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