• THE OUTSIDE VIEW
  • SEPTEMBER 27, 2021

Best Arbitrage Funds in 2021 to Park Money for the Short-Term

For years, mutual fund investors have lived under the impression, that liquid funds are their only saviour when it comes to planning and investing for short-term financial goals. Investors have been programmed to think that equity and short-term goals are a lethal combination. This is akin to the blinkers tied to horses to ensure that they can look only in one direction and not sideways. But it's time that we put an end to this fallacy for there is a type of mutual fund apart from liquid funds, which may be ideal for your short-term financial goals - the Arbitrage Funds.

[Read More: Arbitrage Funds Vs Liquid Funds Vs Savings Bank Account]

Now you must be wondering, 'what are arbitrage funds?

Honestly, the name sounds like a fancy French dessert! Well, if you too are confused about what are arbitrage funds or how arbitrage funds work, then fortunately you are not alone. A majority of retail investors have been deterred from investing in arbitrage funds because their modus operandi is quite confusing. But this needn't be the case here onwards.

In this article, we are diving deep into the complex world of Arbitrage Funds to discover the five best Arbitrage Funds in 2021, suitable for your short-term financial goals.

5 Best Arbitrage Funds in 2021, for your Short-Term Financial Goals

Best Arbitrage Funds in 2021 1-Year Return (%) 3-Year Return (%) 5-Year Return (%) Expense Ratio (%) AUM (Rs Cr)
Kotak Equity Arbitrage Fund 4.54 5.59 6 0.44 25,745.58
Aditya Birla Sun Life Arbitrage Fund 4.53 5.6 5.98 0.31 9,195.60
ICICI Prudential Equity Arbitrage Fund 4.4 5.51 5.94 0.41 15,752.72
Nippon India Arbitrage Fund 4.5 5.74 6.18 0.34 12,972.41
HDFC Arbitrage Fund 4.38 5.24 5.62 0.4 8,262.32
Data as of 21st September 2021
(Source: ACE MF, PersonalFN Research)

We will be studying each of these best Arbitrage Funds in 2021 in detail, later in the article. But before that, it is important for you to fully understand the meaning of Arbitrage Funds and how they work.

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What are Arbitrage Funds? - Definition of Arbitrage Funds

The Securities and Exchange Board of India (SEBI) defines arbitrage funds as, "a mutual fund scheme following arbitrage strategy and investing minimum 65% of its total assets in equity and equity-related instruments."

So, basically, Arbitrage Funds invest a minimum of 65% of the corpus in equity and the balance of 35% in debt and cash instruments. This is why 'technically' Arbitrage Funds are a type of hybrid fund but owing to dominant equity allocation, from a taxation angle, Arbitrage Funds are classified as equity-oriented. The objective of the Arbitrage Fund is not necessary to use the balance 35% in debt and cash to hedge the portfolio, because the equity portion is already hedged. The objective behind 35% debt and cash investments is to handle redemption pressure from investors.

Note two important points from the above definition of Arbitrage Funds:

  1. Arbitrage Funds must follow an arbitrage strategy.
  2. Arbitrage Funds are equity-oriented mutual funds in the strictest sense as they invest a minimum of 65% of their total assets in equity i.e. stocks.

To understand what are Arbitrage Funds, you first need to understand the arbitrage strategy. Wikipedia defines arbitrage as the simultaneous buying and selling of securities, currencies or commodities in different markets or in derivatives format to take advantage of differing prices of the same asset.

How Does an Arbitrage Fund Work?

Arbitrage Funds aims to exploit the price differential in two different segments (spot and futures or cash and derivatives) of the equity market. They buy stocks in the spot market and sell in the future market simultaneously thereby making gains with the price differential (called the spread).

The differential usually is in sync with the prevailing interest rates in the economy; but depending on the market volatility, it could sometimes be higher as well. That being said, these are short-term opportunities that spring up due to a lack of information to a set of market participants in one of the markets.

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Since the transactions are in either direction, the positions are completely hedged. And the remaining 35% of the total asset is deployed in debt and money market instruments.

Let us understand Arbitrage Funds and how Arbitrage Funds work with the example below -

  • The share price of ITC Ltd. on the National Stock Exchange is Rs 232.95 as on 20th September 2021. Mr. Ram buys 3,200 shares from NSE.
  • Simultaneously, he will sell one lot (1 lot of ITC is 3,200 shares) in the futures market. Let's say he sells one futures lot at Rs 243.90.

Now, Mr Ram is aware that the share price of ITC in the spot will converge with the futures price on expiry. By buying in spot and selling in futures, Mr Ram has managed to create risk-free return of Rs 35,040 (243.90-232.95 * 3,200). This is known as the arbitrage strategy.

Recall the definition of arbitrage funds -

  • Simultaneously buying and selling In different markets (spot and futures)
  • Of the same asset (1 lot of ITC Ltd.)
  • To take advantage of the price difference, also known as the spread (Rs 243.90 in futures vs Rs 232.95 in the spot market)

Now you might have noticed that we have underlined the term risk-free return in the above example. This is done purposely to stress the fact that there is minimal to no risk because the positions are hedged --meaning, in the case of Arbitrage Funds the underlying securities are squared-off in the futures market. So, the fund manager does not have to worry about adverse price movements since he has hedged his cash position with a futures contract.

Where do Arbitrage Funds Invest?

Arbitrage Funds can invest across three asset classes -

In the equity portion, the fund manager of an Arbitrage Fund has the freedom to choose which stocks to invest in depending on the arbitrage opportunity available. While for the debt portion, the top-quality Arbitrage Funds invest mainly in AAA-rated debt papers like sovereign bonds, state government bonds, certificates of deposits, commercial papers, etc., and the cash component is mainly parked in Treasury bills (across maturities), margin money and repo instruments.

Advantages of Arbitrage Funds - Why Should You Invest in Arbitrage Funds?

  1. Opportunity to Participate in Arbitrage Strategy: While lucrative, arbitrage opportunities are scarce and time-sensitive as the price in the spot and futures market would eventually converge. So, the fund managers are on a constant vigil to forage for arbitrage opportunities in the market.

    Retail investors do not have the time or resources to probe for such arbitrage opportunities and hence, Arbitrage Funds are a worthy choice for them as the fund manager and his team of experienced professionals identify and capitalise on lucrative arbitrage opportunities.

  2. Significant Position with Limited Capital: In futures trading, you only have to pay margin amount to participate in a trade. In the above example, the total value of the transaction is Rs 7.8 Lakhs (Rs 243.90 * 3,200). But Ram only has to pay an initial margin amount of let's assume 15% of the contract value, which comes to Rs 1.17 lakhs. With limited capital, Ram has managed to generate 29.93% returns. Now, Ram could have made much higher profits if only he had access to more capital. The fund manager of an Arbitrage Fund has ample capital (pooled from lakhs of investors) to undertake big positions in the futures market and earn substantial profits, which may not be possible to do for an individual investor.
  3. Higher Returns: Arbitrage Funds have managed to generate superior returns than Overnight Funds which are considered to be the safest amongst the sub-categories of debt mutual funds in India. They have also managed to perform in line with liquid funds as reflected in the graph below.

    [Read More: Liquid Funds v/s Overnight Funds: Where to Park Your Short-Term Money?]

  4. Taxation Benefit: As mentioned earlier, from a taxation angle, Arbitrage Funds are classified as equity-oriented mutual funds. And this is probably the biggest advantage of the Arbitrage Funds and the primary reason why many investors who are looking to invest for the short-term are drawn to Arbitrage Funds. When you invest in liquid funds, you pay a short-term capital gains tax on redemption within a period of three years. But like equity mutual funds, the holding period considered for taxation in the case of Arbitrage Funds is only 12 months. So, to qualify for long term capital gains, you need not stay invested in the fund for 36 months. You can simply redeem from Arbitrage Funds after 12 months, and you will end up saving as much as 5%-15% in taxes.
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    How are Arbitrage Funds Taxed? - Arbitrage Fund Taxation

    Since, Arbitrage Funds maintain a 65% equity allocation to follow equity taxation, the long-term holding period for Arbitrage Funds is typically 12 months.

    • If you redeem your Arbitrage Fund units before 12 months, you are liable to pay a Short-Term Capital Gains tax (STCG) @ flat 15%.
    • If you redeem from Arbitrage Funds after 12 months, but your capital gains are less than Rs 1 lakh in a financial year, then your Long Term Capital Gains (LTCG) are exempt from tax.
    • If you redeem from Arbitrage Funds after 12 months and your Long Term Capital Gains are more than Rs 1 Lakh in a financial year, then you are liable to pay LTCG tax @10% for the gains over Rs 1 Lakh.
    • Dividends earned from Arbitrage Funds are added to the investor's overall income and taxed as per his/her income tax slabs.
    • If the dividend income from Arbitrage Funds exceed Rs 5,000 in a financial year, then a Tax Deducted at Source (TDS) @ 10% is deducted by the fund house before distributing the dividend.

    Best Arbitrage Funds in 2021 for your Short-Term Financial Goals

    Let us now look at the five best (top-performing) Arbitrage Funds in 2021, for your short-term financial goals.

    1. Kotak Equity Arbitrage Fund is one of the best arbitrage funds in 2021, having generated a one-year return of 4.51% as of 21st September 2021. It has also done well in the longer duration of 5-years with a CAGR of 6.01% as of 21st September 2021. The fund is popular as evident from the mammoth AUM of Rs 25,746 crore, one of the highest in the Arbitrage Fund category. The fund's direct plan has a very reasonable expense ratio of 0.44% and has managed to generate an alpha of 2.09% whilst maintaining a standard deviation of 0.79%.

    One of the primary reasons why Kotak Equity Arbitrage is the best Arbitrage Fund in 2021, is the fact that it invests only in AAA-rated debt and money market instruments. As of 31st August 2021, Kotak Equity Arbitrage Fund has held 67.5% in domestic equities, 28.2% in domestic mutual fund units, 3.5% in cash equivalents and 0.8% in rights.

    2. Aditya Birla Sun Life Arbitrage Fund comes second in our list of the best Arbitrage Funds in 2021. The fund has generated a one-year return of 4.54% and a 5-year return of 6% as of 21st September 2021. The fund has a decent AUM of Rs 9,196 crores as of 31st August 2021. It has done reasonably well with regards to risk-reward ratios as it has managed to generate an alpha of 2.07% over its benchmark with a Sharpe ratio of 2.03% and a Sortino ratio of 2.81%. The fund also has a low expense ratio of 0.31% under its direct plan, making it ideal for investors.

    3. The next best arbitrage fund in 2021 is ICICI Prudential Equity Arbitrage Fund. The fund comes with one of the lowest expense ratios at 0.41% under the direct plan in the arbitrage fund category. It has generated a one-year return of 4.40% as of 21st September 2021. The fund invests 69.9% in domestic equities, 18.2% in treasury bills, 8.8% in cash equivalent and cash equivalents, 2.5% in commercial paper and 0.7% in corporate debt.

    The fund has the second-highest AUM of Rs 15,752.72 crores as of 31st August 2021 in the Arbitrage Fund category. The primary reason why ICICI Prudential Equity Arbitrage Fund is one of the best Arbitrage Funds in 2021, is the fact that it has managed to create an alpha of 2.07% over its benchmark coupled with a decent Sharpe ratio of 1.82% and Sortino ratio of 2.55% as on 21st September 2021.

    4. Nippon India Arbitrage Fund makes it to our list of best arbitrage funds in 2021, with a one-year return of 4.50% as of 21st September 2021. The fund is also popular among investors as it has accumulated an AUM of Rs 12,792.41 crores as of 31st August 2021. The fund invests 67.8% in domestic equities, 9.4% in domestic mutual fund units, 9.4% in government securities, 7.6% in cash and cash equivalents, 3.2% in treasury bills, 1.7% in commercial papers and 0.8% in corporate debt. The fund has managed to generate an alpha of 2.28% over its benchmark with a Sharpe ratio of 2.10% and a Sortino ratio of 3.33% as of 31st August 2021. The fund comes with an expense ratio of 0.34 % under the direct plan.

    5. And the final entry in our list of best Arbitrage Fund in 2021, is HDFC Arbitrage Fund. The fund has generated a one-year return of 4.38% and a 5-year return of 5.62% as of 21st September 2021. The fund has a decent AUM of Rs 8,262 crores and comes with an expense ratio of 0.40% under the direct plan. It currently invests 66.2% in equity, 16% in treasury bills, 9.1% in government securities, 6.4% in cash and cash equivalents, 1.2% in corporate debt and 1.1% in margin deposits. The fund has generated an alpha of 1.65% over its benchmark with a Sharpe ratio of 1.57% and a Sortino ratio of 2.17%.

    While lucrative, we would refrain investors from allocating a sizeable portion of their portfolio to Arbitrage Funds. Investors should instead follow an asset allocation strategy that adheres to their risk profile and investment horizon. Read our article on the best debt funds to invest in 2021 for short-term investors.

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    Author: PersonalFN Content & Research Team

    This article first appeared on PersonalFN here.

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    PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

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