Why are arbitrage funds attracting record investor money

Summary: Investors are rushing to arbitrage funds. We speak with Hiten Shah, manager of India’s largest arbitrage fund, to decode how these funds work, what’s powering the inflows and why they might deserve a spot in your portfolio. Get clarity on spreads, tax benefits and smart risk control.

Arbitrage funds are having their moment. In just four months, the category has pulled in nearly Rs 50,000 crore—making it one of the hottest short-term parking spots for investors’ money. Steering the largest of the lot, the Rs 71,600-crore Kotak Arbitrage Fund, is Hiten Shah. With around 18 years of experience, the fund’s manager focuses on steady performance while swiftly acting on opportunities to lock in returns.

In this conversation, Shah breaks down how arbitrage funds really work, what’s driving the recent surge in inflows and why they’re becoming a key diversifier in investor portfolios amid changing interest rate cycles.

What exactly is an arbitrage fund, and how does it generate returns?

It is based on the concept of the cost of carry. What does that mean? Suppose you're buying equity, you need to pay 100 per cent upfront. But if you're buying futures, then you only need to pay a margin to the exchange. Therefore, the funds left with the investor or the person buying futures can be deployed into other opportunities, such as other debt funds that offer returns. Essentially, arbitrage funds are based on the concept of the cost of carry.

For example, let's say the cost of borrowing money for an investor buying futures is around 9 per cent. In that case, the price of the futures would usually be about 7-8 per cent higher than the cash (spot) price. Thus, the difference between the cash price and the futures price, while not always exact, generally reflects the cost of carry in the short term, which is the cost of holding that position until expiry.

Simply put, the arbitrage category has followed short-term interest rates over the last 10 to 15 years. When interest rates were higher, around 8–9 per cent about 15 years ago, the arbitrage category also yielded returns of around 8-9 per cent. During Covid, when interest rates fell to 3–4 per cent, the arbitrage category returns also dropped to 3-4 per cent.

Following that, with interest rates rising again and short-term interest rates reaching 7 per cent, arbitrage category returns also increased, reaching 7-8 per cent over the last year. Basically, it mimics the short-term interest rate prevailing in the market.

What is your current cash-futures spread range, and how does it compare to historical ranges? Are there any key sectors currently offering better arbitrage opportunities?

We are sector-agnostic. Wherever the premiums are higher, money is deployed into those specific stocks. For example, when markets are in a bullish phase, mid-cap and small-cap stocks in the derivatives list may offer higher spreads compared to large caps in the list. Because at that time, mid and small caps tend to perform better than their large-cap counterparts.

So, it depends on the market scenario that's playing out. When markets are in a bullish phase, your arbitrage returns or yields tend to be higher, and whenever the market enters a bearish phase, those returns tend to decrease.

Arbitrage funds have received over Rs 43,000 crore in inflows in the last three months. What are the key drivers behind this sharp jump?

Over the last year, we've seen that this category has yielded better returns compared to short-term debt funds. For instance, 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.

Plus, the arbitrage category offers diversification. What do I mean by that? See, more than two-thirds of the portfolio is invested in cash-futures arbitrage, where interest rate risk is not there. And only one-third or even less is invested in debt. In the event of interest rate volatility or movement, this category helps provide diversification against such volatility. That's why we've seen strong inflows over the last three to six months.

We often observe fluctuations in inflows into arbitrage funds, which rise and fall cyclically. Why does this category witness such ups and downs in investor interest?

As I mentioned earlier, arbitrage fund returns tend to move in line with short-term interest rates in the market. For example, at times when short-term debt funds or short-term interest rates offer better returns than arbitrage funds, investors tend to move out of them and deploy that money into short-term debt.  And the reverse also happens. When arbitrage returns become more attractive than those of short-term debt funds, money flows back into arbitrage. So, investor interest shifts depending on where better short-term opportunities are available.

Since the April 2023 debt fund tax changes, arbitrage funds have become relatively more attractive. Do you think taxes have primarily driven the inflows?

It may be one of the reasons, but not the primary reason. As I mentioned, on a gross return basis, this category has also yielded better returns compared to other short-term debt funds. Additionally, investors today are more informed and understand that this category should be part of their portfolio for diversification.

For example, with a fixed deposit (FD), a retail investor might have to stay locked in for one year. However, with an arbitrage fund, although there is an exit load of one month, the investor can withdraw money at any time after that. Additionally, in debt funds, the tax is now based on the investor's income slab. However, in arbitrage funds, taxation follows capital gains rules, which are classified as either short-term or long-term, depending on the holding period. So, that can be an added benefit, depending on the prevailing tax treatment.

But what will happen if flows continue to remain strong and open interest (of the universe) stays at the same level?

That would create a demand-supply mismatch. If there's a sudden increase in AUM (assets under management) but the arbitrage universe remains unchanged, then yes, returns may decrease.

However, what we've observed over time is a cyclical pattern. Whenever the return dips and falls below short-term debt, we start seeing redemptions. That money moves out of arbitrage and into debt funds. Then, when arbitrage becomes attractive again, money flows back in. So, this category tends to balance itself out based on return expectations and relative performance.

Your fund has delivered consistent returns over time. What has been the core strategy or discipline that ensures this consistency, especially in fluctuating markets?

At Kotak Mutual Fund, we've always believed in consistency because we want every investor, whether they are new or existing, to have a positive experience.

We've studied the factors that contribute to volatility in this category. For example, in the debt portion of the fund (which is the residual part), we take no duration risk. If we took longer-duration debt, we might earn more in the long term due to higher coupons; however, in the short term, there could be volatility resulting from interest rate movements. And that's not what investors in this category are looking for; they're here for stability. So, we take no credit or duration risk, which helps ensure consistency in returns.

On the arbitrage side, we also engage in a significant amount of intra-month activity. Let me explain. Suppose we enter a trade at the start of the month with a 1 per cent spread. If, after just one week, that spread disappears and the trade moves to parity, we don't wait until expiry. We exit the position early and redeploy that money into another cash-futures arbitrage trade. If no good arbitrage opportunities are available at the time, we temporarily park the money in short-term debt until a new opportunity arises.

This active approach helps us capture spreads more efficiently. We strive not to miss any good opportunities as they arise throughout the month.

Looking ahead, do you expect arbitrage spreads to remain healthy, or could we see compression as flows increase and volatility normalises?

I can't comment on the future, but what I can share is our experience from the last 15 years. On a rolling six-month basis, arbitrage funds have generally outperformed other short-term investment avenues.

Over this period, we've seen both bullish and bearish markets, with interest rates fluctuating up and down. Nevertheless, if an investor stayed invested for more than six months, their experience has been largely positive.

As I said earlier, this category tends to self-correct. When returns fall, we usually see redemptions. That leads to a rebalancing, and then the return environment improves again.

In terms of post-tax returns and risk-adjusted yield, how would you compare arbitrage funds with liquid and ultra-short duration funds today?

Firstly, arbitrage funds don't have any open positions. Every stock in the portfolio is fully hedged against market risk. Not even a single share remains unhedged. Thus, in terms of risk, arbitrage funds can be compared to liquid funds, as they carry minimal risk.

Additionally, as I mentioned earlier, this category has performed well over the past 15 years compared to other short-term instruments. And with the taxation benefit arbitrage funds offer, especially over longer holding periods, they become even more attractive in terms of post-tax, risk-adjusted returns.

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