What is your recommendation on arbitrage funds as an alternative to ultra-short-term or liquid funds for a time frame of one year, with capital protection being a critical requirement with some growth?
Yes, for a one-year timeframe and more, it makes sense. The character of an arbitrage fund is quite similar to a liquid fund but the tax treatment is like that of an equity fund. So, for anybody falling in the highest tax bracket with at least one year of holding period, the capital gain treatment makes arbitrage funds convenient.
Over a one-year time frame, arbitrage funds will give you returns like liquid funds or maybe little more. But these funds have a different kind of risk and that risk has not quite been visible so far. However, there were some instances in the past where arbitrage funds do not find enough arbitrage opportunities and by their very design, they have a fallback to invest in liquid securities. So, they become like liquid funds in the absence of such investment avenues, even though they are not designed as one.
Arbitrage funds try to derive returns by buying in the cash market and selling in the future markets. So, they try to pocket all the mispriced opportunities. So, these funds require very high execution capabilities. I think one or two funds have proven to be far more impressive than others - eg Kotak Equity Arbitrage Fund has turned out to be very impressive.
But be mindful of the fact that these funds can be a little volatile. However, in a one-year time frame, you can go with it, as it does not really amount to assuming any significant risk.