What are arbitrage funds and can they sustain the surge? Here's what expert has to say

Arbitrage funds have recently made headlines for their impressive performance, attracting significant attention from investors. With a remarkable influx of nearly Rs 16,000 crore in April 2024 alone, these funds have pushed their assets under management (AUM) to an astonishing Rs 1.90 lakh crore. But the question remains: Can this bull run continue? This article delves deeper into what arbitrage funds are, their performance, and what the future may hold for them.

What Exactly Are Arbitrage Funds?

Arbitrage funds operate on a relatively straightforward principle - they aim to capitalize on price differences between the cash and futures markets. According to Chakrivardhan Kuppala, Cofounder and Executive Director at Prime Wealth Finserv Pvt Ltd., by buying stocks in the cash market and simultaneously selling them in the futures market, these funds lock in a price differential that they later profit from at the time of settlement. This strategy is not only smart but also safe, as it fully hedges equity exposure, eliminating the risk typically associated with direct stock investments.

For taxation purposes, arbitrage funds are treated as equity funds, requiring them to invest at least 65% of their assets in equities. This classification offers them a tax advantage over traditional liquid funds, potentially yielding better after-tax returns for investors.

Recent Performance and Market Influence

"Over the past year, arbitrage funds have posted an average return of 7.43 per cent, and 5.29% over the last three years. These funds have seen their highest yearly inflows during the financial year 2024, with a whopping Rs 90,000 crore added, representing a 127 per cent increase in AUM. This influx is largely attributed to attractive arbitrage opportunities and favourable market conditions," Kuppala said.

However, the performance of these funds is not just about current returns but also about potential future opportunities. It is expected that returns in the coming months will hinge on several factors, including market volatility, interest rate movements, and the overall direction of the equity markets. A bullish outlook on the markets tends to widen the arbitrage spread, enhancing potential returns.

The Impact of External Factors

"Recent legislative changes, such as the Finance Act of 2023, which revised the taxation on non-equity mutual funds, have inadvertently favoured arbitrage funds, leading to higher inflows. Moreover, ongoing global uncertainties, geopolitical tensions, and domestic factors like the upcoming national elections are expected to maintain market volatility, thereby providing fertile ground for arbitrage strategies to thrive," he said.

Potential Challenges

Despite the optimistic scenario, there are a few clouds on the horizon. The growing AUM could lead to reduced profitability due to narrower spreads in arbitrage opportunities. Also, interest rate fluctuations could mirror changes in the returns of these funds, potentially impacting their attractiveness.

What should the investors do? 

Arbitrage funds should not be viewed as a quick parking space for funds, like liquid funds. They are better suited for investors who can commit to a minimum investment horizon of six months or more. This approach shields them from periods when futures may not trade at a premium over the cash market, which could lead to returns that are lower than those of liquid funds.