Arbitrage, if I have to really keep it simple, is to buy an asset for cheap in one market and sell the same asset for a higher price in another market. Exploiting price differences between the cash and future market is an example of an arbitrage opportunity. These are typically small but can be systematically captured. 

You can read our quick intro to arbitrage funds.

My goal with this article series is to take a data-driven approach to evaluate arbitrage funds. First, lets talk about the marketing message associated with Arbitrage Funds:

Q: Why Should You Invest in Arbitrage Funds?

A: Whenever you see any article or piece of content asking this question, the usual response is:

  1. Low Risk Profile
    1. Less sensitive to market volatility compared to pure equity funds.
    2. Ideal for conservative investors looking for capital protection with modest growth.
    3. Volatility is dampened due to hedging with futures contracts.
  2. Tax Efficiency
    1. Treated as equity funds (due to >65% equity exposure), offering better tax treatment than debt funds.
      1. Long-Term Capital Gains (LTCG): 12.5% on gains exceeding ₹1.25 lakh per financial year, holding period is ≤ 12 months
      2. Short-Term Capital Gains (STCG): 20%, holding period is ≤ 12 months
  3. Diversification Benefit
    1. Invest in a mix of equity and derivatives.
    2. Strategy reduces correlation with the equity market, providing portfolio stability.
  4. Potential in Volatile Markets
    1. Arbitrage spreads widen during volatility, increasing potential profits.

We’ll explore each of these points one by one by looking at some actual data.

Low Risk: 

Less sensitive to market volatility compared to equity funds. 

But is it really low risk? Let's dive in - we’ll use two measures of risk here - one is volatility and second is maxDD (max drawdown). Both are somewhat correlated, but sometimes you can see higher drawdowns in assets with lower volatility (we’ll discuss this in a later article)

Lets pick two representative mutual funds, one each from the arbitrage and flexi cap category. I’ll pick these two specifically coz I’m invested in them personally:

  • PPFAS flexi for Equity flexicap, and
  • Tata Arbitrage for Arbitrage​​

Yup, the arbitrage fund has a much lower annualised volatility than the flexi cap fund.

We can also backtest the 10-year return for arbitrage funds and check out the volatility AND max drawdown of each fund in the arbitrage subcategory  investHQ.

This is what data shows.

You’ll notice that besides Sundaram’s arbitrage fund, all other arb funds have a max DD of less than 1%. (More details on what happened with Sundaram Arbitrage Fund in this article.)

A same table generated from the backtest for flexi cap funds shows that if we use volatility and maxDD to quantify risk, the arbitrage fund subcategory is far less riskier than pure equity funds. Here’s the flexi cap table:

Now let’s look at:

Tax Efficiency: 

Treated as equity funds (due to >65% equity exposure), offering better tax treatment than debt funds.

Before we elaborate on this point, lets first look at 

SEBI's classification for Arbitrage Funds:

Under SEBI's mutual fund classification framework, Arbitrage Funds fall under the Hybrid category, and are defined as:

"Schemes that invest at least 65% of total assets in equity and equity-related instruments on an average monthly basis in arbitrage opportunities."

What about the remaining 35%?

The remaining (up to 35%) assets can be invested in other instruments, subject to the fund’s investment objective and scheme information document (SID). There is no specific restriction from SEBI on the exact instruments for this 35%, so in practice:

  • Funds can invest in debt instruments (e.g., money market instruments, treasury bills, corporate bonds)
  • Funds may hold cash and equivalents
  • Some might take limited exposure to unhedged equity positions, although this is typically very minimal in true arbitrage funds to avoid risk

SEBI has classified Arbitrage funds in the hybrid category with the rule that minimum 65% of the assets will be invested in equity and equity-related instruments. 

Most arbitrage funds I’ve seen so far invest the remaining 35% in debt-like securities, which could be their own AMC’s money-market or liquid mutual funds, NCDs, etc.

But why 65%? What’s the significance of 65%?

It’s because of tax reasons. The government says if holding is greater than 65% in equity, then it should be taxed as equity, which is favourable for HNI’s who are in the higher tax bracket. 

How are they taxed?​

  • Long-Term Capital Gains (LTCG): 12.5% on gains exceeding ₹1.25 lakh per financial year, holding period is ≤ 12 months
  • Short-Term Capital Gains (STCG): 20%, holding period is ≤ 12 months

Diversification Benefit

Offer diversification benefits by investing in a mix of equity and derivative instruments, which helps spread risk and enhance portfolio stability. Strategy reduces correlation with the equity market, providing portfolio stability.

What I think is most funds have at least 65% of their AUM deployed in cash vs future carry arbitrage strategies, whose returns should be relatively uncorrelated with the broad equity market, so this is correct in theory.

Potential for Profit in Volatile Markets: 

Can be particularly lucrative during periods of increased market volatility, as they profit from price discrepancies across different markets.

This is an interesting observation. Do future prices deviate more than the spot price during market uncertainty and periods of high volatility? Yes they do, in theory. 

 If this is true, then arbitrage funds will make more money. Let’s verify this. 

Rolling XIRR over a 2-month period will show a clear picture of how much better the fund performs during volatile periods. 

Here is a point estimate from that rolling return chart, where you see the arb fund returns 8.5% annualised, vs a -52% XIRR for NIFTYBEES during the COVID period:

The Tata Arbitrage fund has returned 6.5% XIRR over its lifetime, see here:

So based on this single data point, yes the arbitrage fund outperformed NIFTY, as well its own historical performance (8.5% vs 6.5%).

We decided to run a backtest for the COVID period, and here is the XIRR for the arbitrage funds during that time (see image below):

(01-03-2020 to 01-05-2020 and 10-year comparison)

Bottom Line:

It does beat NIFTY during the COVID and it also beats its own long term track record.

Caveat:

This is only a point estimate, for only one arbitrage fund. A more rigorous way to show this would be to take the rolling return chart with a 2-month window for TATA.

So we looked at each of these “virtues” of an arbitrage fund with a little bit of data, and it seems that arb funds do indeed hold up strong when compared to more liquid debt fund categories like money-market and liquid funds.

In the last article of the series, we’ll go even deeper into arbitrage funds - where we uncover some hidden risks of investing in these instruments.