Arbitrage funds unimpressive performance: To hold or to exit?

For the past two months, arbitrage funds have been generating negative returns. This has forced many investors to think about whether to hold or exit from arbitrage funds? Under such a circumstance, let’s know what investors should do.

Firstly, let us understand how arbitrage funds work. As per Securities & Exchange Board of India’s (SEBI) circular on rationalisation of mutual funds, arbitrage funds are considered to be hybrid schemes but in the true sense, they are not. Basically, arbitrage funds take the opportunities from pricing differential between the cash market and the derivatives market. However, if in case no such opportunities are available, they remain invested in debt. Due to this, they have been categorised as hybrid schemes.

Secondly, if your investment horizon is not more than one year, then arbitrage funds would be ideal for you. Arbitrage funds help in getting tax-efficient returns. However, in the absence of spreads or if negative spreads persist, then the returns of arbitrage funds get impacted. For instance, in the month of June and July 2020, arbitrage funds witnessed low returns. This was amid a deep correction in March 2020 that led many stocks to trade at discount to their price than at premium, which diluted the returns of these funds. In March 2020, the arbitrage spread was negative 10 to 20 bps (100 bps equals one per cent).

Arbitrage funds are low-risk schemes similar to fixed income funds. Hence, they are suitable for investors having a low-risk appetite, seeking better tax-adjusted returns. Also, investors in higher tax slabs with an investment horizon of less than one year can invest in arbitrage funds instead of debt funds. Hence, investors need to decide what their investment horizon is and in which tax bracket they fall.