Arbitrage funds aim to capture the difference between stock prices in the cash and futures markets. These funds aim to capture such price differential by simultaneously buying the same quantity of shares in the cash market and selling in the futures market. This way, they do not take any stock-specific risk. As the expiry of the futures contract nears, the prices converge and the fund manager reverses the trade done earlier, to complete the second leg of the transaction. Since these trades are guaranteed on the stock exchange, they are perceived to be free of counter party risk.
Contrary to the belief of many investors, arbitrage funds do not deliver stable returns. The returns from the strategy mainly depend on two key determinants : interest rates prevailing in the economy and price volatility in stock markets. The higher the rate of interest, the higher the cost of funding for the futures position. This gets reflected in the high premium investors need to pay for futures in a bullish market. In case the rates are low, the cost of carry and thereby the premium erodes for all derivative instruments.
If the price volatility is high with an upward moving bias, then you make more money in the cash ; future arbitrage. But if there is a bearish sentiment in the market and the stock is quoting at discount in futures market or at a negligible premium, then there is little money to be made for mutual funds. Arbitrage funds returns have been impacted by these two key factors. Daily rolling return for the one-year period has gone down to 3.98% on 7th October 2020 for arbitrage funds as a category compared to 5.91% as on 1st January 2020.
Profits in excess of ₹1 lakh earned on units of arbitrage funds held for more than twelve months, are treated as long term capital gains and taxed at 10%. In case investments are sold in less than one year, the gains are taxed at 15%, which is less than the tax rates charged on bond funds. But they cannot be used as a replacement for liquid or ultra-short bond funds.
Calibrate your expectation of returns downwards. If the short term rates remain range-bound with downward bias, as indicated by the RBI Governor, in the foreseeable future, then you too should not expect significant uptick in returns from these funds. Another risk that you cannot ignore is the downward volatility in the market. At times when the futures prices quote at significant discount to cash markets, returns from these funds take a beating.