Last Updated on May 29, 2020 at 10:45 am
With RBI 7.75% bonds no longer available and yields from tax-free bonds destroyed by increasing demand, investors looking for a “reasonable” mix of low volatility, credit quality, tax efficiency and liquidity can consider arbitrage mutual funds for long-term goals. How can return can we expect from arbitrage funds? An analysis of all the funds in the category.
The crudest definition of Arbitrage is to buy a product in a place (market) where is it cheap and sell it in another place where it is expensive and profit from the difference. Naturally, a bit more work is necessary to ensure the profit is reasonably risk-free. This is accomplished in the capital markets using a combination of the cash (spot) market and the futures market.
For simple introduction consult, How Arbitrage Mutual Funds Work, also see Generating tax-free income from arbitrage mutual funds. use arbitrage funds as a debt component for my son’s future goal: Lessons from investing for my son’s future for ten years.
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Before we begin, it is important to clarify what a “return expectation” means. In the case of equity funds, the difference bet max and min return (SIP or lump sum) possible for any particular duration is so wide that one cannot “expect much” and must initiate a plan conservatively: Do not expect returns from mutual fund SIPs! Do this instead!
So return expectation is a reasonable estimate that we can use in our planning. In the case of arbitrage funds, as long the quality of the bonds in the portfolio is good (it need not be!) and not subject to much interest rate risk, the typical day to day volatility would resemble a low-duration debt fund.
They can, however, get more volatile during a market crisis when the demand vs supply in one market does not match that of the other: Why arbitrage funds become more volatile when market uncertainty increases.
In general, with a reasonable quality bond portfolio and 0-5% of direct equity exposure, an arbitrage fund can be used for long-term goals (greater than 5 years). Naturally, the debt-fund like NAV volatility and equity-fund like taxation make it suitable for those in 20% and 30% slabs.
Those who are young and in the 5% slab will need to ask themselves if they are going to remain there for life or have plans to move ahead.
How to select an arbitrage fund?
- Read the scheme information document!
- Do not be lazy looking at the star rating or latest portfolio at Value Research
- Choose a fund that invests in high-quality bonds (study past factsheets randomly to check) with a reasonably large AUM.
- Choose a fund that minimises direct equity exposure (preferably zero as explicitly stated in the scheme document). In the factsheet, if the equity exposure is listed as plus 65% the derivative exposure will be listed as minus 65%. Ideally, the plus and minus values should be as close to each other as possible. The balance is direct stock exposure (unhedged)
- If expense ratio matters to you, do not go by the fund that has the current lowest. Check past fact sheets. A low expense ratio could just be a temporary invitation to invest.
We shall now inspect the rolling returns for arbitrage funds (direct plans) since inception. The max and min returns are indicated to show the past spread in returns. Past performance may not be reproduced in future but when did that stop us?! Please note, Principal Arbitrage Fund suffered a credit downgrade (IL &FS).
One-year rolling returns
| Scheme Name | Max (1Y) | Min (1Y) |
| Principal Arbitrage Fund(G)-Direct Plan | 6.4 | -1.1 |
| UTI Arbitrage Fund(G)-Direct Plan | 15.7 | 2.3 |
| Essel Arbitrage Fund(G)-Direct Plan | 6.3 | 3.3 |
| JM Arbitrage Fund(G)-Direct Plan | 10.4 | 4.9 |
| BOI AXA Arbitrage Fund(G)-Direct Plan | 6.8 | 5.3 |
| SBI Arbitrage Opportunities Fund(G)-Direct Plan | 9.9 | 5.7 |
| Indiabulls Arbitrage Fund(G)-Direct Plan | 8.9 | 5.7 |
| HDFC Arbitrage-WP(G)-Direct Plan | 8.3 | 5.8 |
| PGIM India Arbitrage Fund(G)-Direct Plan | 9.2 | 5.8 |
| IDFC Arbitrage Fund(G)-Direct Plan | 10.3 | 6.0 |
| Invesco India Arbitrage Fund(G)-Direct Plan | 9.4 | 6.0 |
| ICICI Pru Equity-Arbitrage Fund(G)-Direct Plan | 10.8 | 6.1 |
| LIC MF Arbitrage Fund(G)-Direct Plan | 6.7 | 6.1 |
| L&T Arbitrage Opp Fund(G)-Direct Plan | 9.2 | 6.1 |
| Nippon India Arbitrage Fund(G)-Direct Plan | 10.3 | 6.1 |
| Axis Arbitrage Fund(G)-Direct Plan | 9.1 | 6.1 |
| Kotak Equity Arbitrage Fund(G)-Direct Plan | 10.7 | 6.2 |
| Aditya Birla SL Arbitrage Fund(G)-Direct Plan | 11.2 | 6.2 |
| BNP Paribas Arbitrage Fund(G)-Direct Plan | 7.5 | 6.2 |
| DSP Arbitrage Fund(G)-Direct Plan | 7.5 | 6.3 |
| Edelweiss Arbitrage Fund(G)-Direct Plan | 9.7 | 6.4 |
| Union Arbitrage Fund(G)-Direct Plan | 7.4 | 6.5 |
| Tata Arbitrage Fund(G)-Direct Plan | 7.7 | 7.0 |
Three-year rolling returns
| Scheme Name | Max (3Y) | Min (3Y) |
| Principal Arbitrage Fund(G)-Direct Plan | 4.0 | 3.2 |
| UTI Arbitrage Fund(G)-Direct Plan | 9.0 | 5.5 |
| JM Arbitrage Fund(G)-Direct Plan | 9.6 | 5.8 |
| HDFC Arbitrage-WP(G)-Direct Plan | 8.1 | 6.4 |
| PGIM India Arbitrage Fund(G)-Direct Plan | 8.2 | 6.6 |
| Indiabulls Arbitrage Fund(G)-Direct Plan | 8.3 | 6.6 |
| Invesco India Arbitrage Fund(G)-Direct Plan | 9.3 | 6.8 |
| SBI Arbitrage Opportunities Fund(G)-Direct Plan | 9.6 | 6.8 |
| ICICI Pru Equity-Arbitrage Fund(G)-Direct Plan | 10.1 | 6.9 |
| Aditya Birla SL Arbitrage Fund(G)-Direct Plan | 9.7 | 6.9 |
| IDFC Arbitrage Fund(G)-Direct Plan | 9.7 | 7.0 |
| L&T Arbitrage Opp Fund(G)-Direct Plan | 8.2 | 7.0 |
| Kotak Equity Arbitrage Fund(G)-Direct Plan | 10.0 | 7.0 |
| Axis Arbitrage Fund(G)-Direct Plan | 8.3 | 7.0 |
| Nippon India Arbitrage Fund(G)-Direct Plan | 9.9 | 7.2 |
| BNP Paribas Arbitrage Fund(G)-Direct Plan | 7.5 | 7.2 |
| Edelweiss Arbitrage Fund(G)-Direct Plan | 8.5 | 7.2 |
Five-year rolling returns
| Scheme Name | Max (5Y) | Min (5Y) |
| UTI Arbitrage Fund(G)-Direct Plan | 8.9 | 6.6 |
| JM Arbitrage Fund(G)-Direct Plan | 9.2 | 6.8 |
| HDFC Arbitrage-WP(G)-Direct Plan | 8.0 | 7.4 |
| SBI Arbitrage Opportunities Fund(G)-Direct Plan | 9.2 | 7.4 |
| PGIM India Arbitrage Fund(G)-Direct Plan | 8.2 | 7.4 |
| Invesco India Arbitrage Fund(G)-Direct Plan | 9.1 | 7.6 |
| IDFC Arbitrage Fund(G)-Direct Plan | 9.4 | 7.7 |
| Aditya Birla SL Arbitrage Fund(G)-Direct Plan | 9.5 | 7.7 |
| Indiabulls Arbitrage Fund(G)-Direct Plan | 8.3 | 7.7 |
| Kotak Equity Arbitrage Fund(G)-Direct Plan | 9.6 | 7.7 |
| ICICI Pru Equity-Arbitrage Fund(G)-Direct Plan | 9.7 | 7.7 |
| L&T Arbitrage Opp Fund(G)-Direct Plan | 8.4 | 7.8 |
| Nippon India Arbitrage Fund(G)-Direct Plan | 9.5 | 7.9 |
| Axis Arbitrage Fund(G)-Direct Plan | 8.6 | 7.9 |
| Edelweiss Arbitrage Fund(G)-Direct Plan | 8.7 | 8.0 |
A 6-7% conservative return estimate is not unreasonable for arbitrage funds
Considering the one lakh (overall) tax-free limit and 10.4% tax on excess gains, those are acceptable returns over a few years given their liquidity.
Trailing Returns
These are returns with respect to 27th May 2020. The last one year returns are fairly decent with that has been happening around the world.
| Scheme Name | 1 Year | 2 Years | 3 Years | 4 Years | 5 Years |
| Essel Arbitrage Fund(G)-Direct Plan | 3.3 | ||||
| Principal Arbitrage Fund(G)-Direct Plan | 4.0 | 1.7 | 3.2 | 4.1 | |
| JM Arbitrage Fund(G)-Direct Plan | 4.9 | 5.7 | 5.8 | 6.5 | 6.9 |
| BOI AXA Arbitrage Fund(G)-Direct Plan | 5.3 | ||||
| PGIM India Arbitrage Fund(G)-Direct Plan | 5.9 | 6.4 | 6.8 | 7.1 | 7.5 |
| HDFC Arbitrage-WP(G)-Direct Plan | 6.0 | 6.5 | 6.6 | 7.0 | 7.4 |
| Indiabulls Arbitrage Fund(G)-Direct Plan | 6.0 | 6.5 | 6.7 | 7.2 | 7.7 |
| SBI Arbitrage Opportunities Fund(G)-Direct Plan | 6.1 | 6.6 | 6.9 | 7.2 | 7.4 |
| LIC MF Arbitrage Fund(G)-Direct Plan | 6.2 | ||||
| IDFC Arbitrage Fund(G)-Direct Plan | 6.3 | 7.1 | 7.2 | 7.4 | 7.7 |
| UTI Arbitrage Fund(G)-Direct Plan | 6.4 | 7.0 | 7.1 | 7.4 | 7.7 |
| ICICI Pru Equity-Arbitrage Fund(G)-Direct Plan | 6.5 | 7.0 | 7.1 | 7.5 | 7.8 |
| Kotak Equity Arbitrage Fund(G)-Direct Plan | 6.5 | 7.0 | 7.2 | 7.5 | 7.8 |
| DSP Arbitrage Fund(G)-Direct Plan | 6.5 | 7.0 | |||
| Aditya Birla SL Arbitrage Fund(G)-Direct Plan | 6.6 | 7.0 | 7.1 | 7.5 | 7.7 |
| Nippon India Arbitrage Fund(G)-Direct Plan | 6.6 | 7.2 | 7.5 | 7.7 | 8.0 |
| Invesco India Arbitrage Fund(G)-Direct Plan | 6.6 | 6.8 | 7.0 | 7.3 | 7.6 |
| Union Arbitrage Fund(G)-Direct Plan | 6.7 | ||||
| L&T Arbitrage Opp Fund(G)-Direct Plan | 6.7 | 7.0 | 7.1 | 7.5 | 7.8 |
| Axis Arbitrage Fund(G)-Direct Plan | 6.8 | 7.2 | 7.4 | 7.7 | 8.0 |
| BNP Paribas Arbitrage Fund(G)-Direct Plan | 6.8 | 7.2 | 7.3 | ||
| Edelweiss Arbitrage Fund(G)-Direct Plan | 7.1 | 7.4 | 7.4 | 7.8 | 8.1 |
| Tata Arbitrage Fund(G)-Direct Plan | 7.4 |
A valid argument against the use of arbitrage funds is, “can I not use money market funds to get similar returns? This way additional risks arising from the use of arbitrage can be avoided”.
Arbitrage funds have resulted in negative returns over six months too. This is unlikely to happen in a money market fund (in the absence of a credit event).
This is indeed true and risk-averse investors who do not want a complicated product like arbitrage but still want better tax benefits compared to bonds or FDs may use money market funds. Those who want even more tax benefits but do not mind the additional volatility can choose arbitrage funds.
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