In an endeavour to achieve higher returns on their investments with less risk involved, investors are constantly in search of different investment options. Initially, investors (especially the risk-averse ones) put their money on debt instruments until the mayhem of corporations defaulting to repay fiasco happened.

Already the finance industry is experiencing a lot of volatility due to macro and microeconomic factors. Equity markets are the foremost to undergo extreme highs and lows. And investing in pure equity is not suitable for the fainthearted.

In this scenario, even aggressive investors are being extra cautious.

And the current volatile environment opens a tiny door of opportunity to exploit the price differences between two markets to generate returns.

In finance, investment opportunities created by the mispricing of an asset in two different markets are called arbitrage opportunities. When you are simultaneously buying and selling the same product in different markets and locking the price differential, it becomes your clear gain, after adjusting the costs.

The mutual fund industry has a separate product category to tap suchmispricing opportunitiesarbitrage funds.

An arbitrage fund is a sub-category ofHybrid fundthat seeks opportunities from differential pricing in two different segments (spot and futures or cash and derivatives) of the equity market. Such opportunities are usually tapped in volatile market conditions.

As per recategorization norms, an arbitrage fund will follow the arbitrage strategy and invest at least 65% of its total assets in equity & equity related instruments as per the mandate under normal and defensive conditions. It will also allocate the remaining assets to debt and money market instruments.

Typically, an arbitrage fund is less risky than thepure equity fundbecause participants are not speculating on market movements. Instead, they bet on the mispricing of a share/asset that has happened between two related markets. It is seen that the mispricing of security is far more frequent in high volatility months than in low volatility months.

Currently, Arbitrage funds are gaining momentum because of the new valuation norms imposed. When the great debacle in the debt market surfaced, several fund houses that had taken the investors for a joy ride were exposed.

Due to these instances, the regulator introduced a slew ofnew regulationsthat was intended to makedebt mutual fundsa lot safer place for investors. Some of those were

Graded exit load imposed on liquid funds along with limits set forth on the duration of the exposure of instrumentsheld.

Capping exposure on debt instruments with credit enhancements to make the debt instruments more transparent to show the actual risk involved.

All debt and money market instruments will have to value their portfolio on a mark-to-market basis now.

After the implementation of these prime regulatory norms, the fund houses reduced the holding duration of the liquid funds, but in turn, the returns have been moderate and that impacted the performance of the funds.

Per se, considering the taxation norms, Arbitrage funds are categorised as equity-oriented schemes. So, any arbitrage fund held for up to 1 year is liable for a Short-term capital gain (STCG) that is taxed at the rate of 15 %.

And fund held for more than 1 year will be treated as Long term capital gain (LTCG), to be taxed at the rate of 10% for gains in excess of Rs 1 lakh in a financial year.

On the other hand, Short-Term Capital Gains (STCG) earned via short-term debt funds for a holding period less than 36 months, are taxed at the applicable rate as per your tax slab.And theLong-Term Capital Gains, i.e. gains made after staying invested for more than three years in case of debt mutual funds are taxed at 20% after opting for the indexation benefit.

Additionally, if one opted for the dividend option, the dividend declared by liquid funds carries effectively 28.84% Dividend Distribution Tax (including surcharge and cess).

In brief, the pros of arbitrage funds outweigh that of Debt funds (liquid funds):

Since the buying and selling of the same asset happens simultaneously, returns of these funds are highly predictable as compared toequity-oriented mutual funds

Ideal for parking money for the short-to-medium termsay for one to two years

A good alternative to keeping money idle in thesavings bank account

The favourable tax treatment and hence are often attractive vis–vis short-term and ultra-short-term debt funds.

Hence from the past few months, the Asset Under Management (AUM) of Arbitrage funds has witnessed growth, as seen from the table below.

However, in terms of performance, the returns of top ten arbitrage funds have been lagging marginally as compared to the benchmark across various time periods. And the average category returns of arbitrage funds have been underperforming.

Thus, it indicates, there are hardly any outliers, which means, the performance of all arbitrage funds, irrespective of whos managing them, is the same.

An Arbitrage Fund is contingent upon market volatility, risk-free rate of returns and its ability to get access to real-time market data.

While market volatility and risk-free returns are the factors that are beyond the control of the fund; access to real-time data has become universal with the advent of sophisticated trading platforms making meaningful arbitrage opportunities hard to find. This leaves them with little margin for errors.

Besides, Arbitrage opportunities dry out under sideways market conditions, which is when the prices are range-bound, or during bear market phases when prices are usually moving down.

In the sideways markets, the spread, i.e. the differential between the cash market and derivatives markets, arent attractive enough for fund managers to take advantage of arbitrage opportunities that might exist.

And in the bear market phases, future market prices trade at a discount to cash market prices. As a result, arbitrage funds get fewer arbitrage opportunities.

When there arent many arbitrage opportunities, arbitrage funds invest a sizable corpus in short-term debt and money market instruments.

When there are ample arbitrage opportunities and markets are trending upwards, arbitrage funds tend to churn their portfolios frequently and under such circumstances, theexpense ratiosof arbitrage fund may shoot up.

Hence, if you have a time horizon of less than one-year, short-term debt funds like liquid funds/overnight funds may still be better options for you. Return potential of arbitrage funds is highly subjective to the market conditions.

To park money for the short-term (up to 2 years), you may consider an arbitrage fund.It makes sense particularly if you are in the 20% or 30% tax bracket.

Alternatively, you may consider short-term debt funds for an investment horizon of up to 2 years. But if you have an investment horizon of less than 1-year, low duration and money market funds would be the preferred choices.

And if you have an extremely short-term time horizon (of less than 6 months), you would benefit from investing inliquid fundsand ultra-short duration funds. Remember that investing in debt funds is not risk-free.

[Read:5 Facets To Look Into While Investing In Debt Mutual Funds]

In the current scenario where interest rates being reduced to curtail the inflationary pressures, shorter maturity papers look attractive, and fund houses, too, are aligning their portfolios accordingly.

However, make sure you have a clear objective in mind, know yourfinancial goals, risk profile, and the time horizon before goals befall before you invest your hard-earned money. Accordingly, you need to invest based on your personalised asset allocation.

Prudent investing and financial discipline are vital measures for long-term financial well-being.

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