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Summary: A low-risk hybrid category is suddenly attracting big money and reaching record asset levels. We find out the reasons behind this surge.
Arbitrage funds, a niche hybrid category that thrives on exploiting price differences between the cash and futures markets, have been on a tear in recent months. In the last four months alone, they have received net inflows of Rs 50,370 crore, pushing total assets under management (AUM) to a record Rs 2.56 lakh crore, second only to dynamic asset allocation funds in the hybrid space.
The recent returns have definitely played a part in their growing popularity. “Over the past year, returns have been as high as 7.5 per cent in direct plans. At the same time, short-term rates may have been in the range of 6-7 per cent. Considering past returns, where this category has clearly performed better, we've observed these inflows,” says Hiten Shah, Fund Manager of Kotak Arbitrage Fund.
Equity-like taxation
The other appeal lies in arbitrage funds’ ability to deliver equity-like tax treatment with debt-like risk.
Since April 2023, debt funds have lost their special lower tax rate for long-term gains. But arbitrage funds are still treated as equity for tax purposes, so their gains are taxed at a lower rate. This makes them more attractive to both regular investors and big institutions.
The ebbs and flows in investment flows
That said, investor interest in arbitrage funds is cyclical. When short-term debt yields exceed arbitrage returns, flows tend to reverse.
And when arbitrage spreads widen, often in bullish markets, money comes back.
Shah notes that the category “self-corrects” as returns and flows adjust over time.
Our take
For investors seeking a low-risk parking avenue with the potential for better post-tax returns than liquid or ultra-short duration debt funds, arbitrage funds remain a compelling option.
A holding period of at least six months can help investors ride out short-term fluctuations.
Also read: Guess which funds have got Rs 43,000 crore in last 90 days?
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