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  4. Arbitrage funds vs liquid funds – which one to invest in?

Arbitrage funds vs liquid funds – which one to invest in?

August 11, 2020

From the questions we receive from you, it seems to us that many of you are keen to use arbitrage funds. However, it is really important for you to first know what goes into generating returns in these products. This article is an attempt to provide the basics and also do a comparison with liquid funds, which is the category to compare with as far as performance goes. This is an article for mutual fund investors and not for those who are already familiar with the concept of arbitrage or have traded in derivatives.

Arbitrage funds seek to generate returns from the mispriced opportunities in equities between the cash and futures market. These funds are required to hold at least 65% in equities (including derivatives) in order to remain as an equity fund under the tax laws. This proportion of equities held varies depending on the mispriced securities that a fund manager is able to identify. Broadly, arbitrage funds’ returns stem from the following:

  • Arbitrage opportunity
  • The interest on deposits which are kept as margin collateral
  • The interest on the remaining debt and liquid component

The last 2 points mentioned above are simple. The first one is the ‘active’ call that a fund manager has to take. It is a function of the opportunities that the market offers – based on spread, open interest and the margin needed for the position. Let’s explain this a bit.

The spread is the difference in the price between the cash equity and the futures market. This primarily determines what returns arbitrage funds can make in their securities. As the spread widens, there is more opportunity to make money. When the spread turns negative – that is when the futures market is at a discount to the spot – then there is a higher risk of loss. This recently happened in March 2020 (and in earlier years too) when the equity markets crashed. But please note that not all the securities collapse to negative territory.

Open interest is the derivative positions that are not closed. Open interest provides a big picture of the trading activity in the market and whether there is increased or decreased participation. Usually, higher open interest enhances the chances of a healthy spread.

The job of a fund manager would be to identify the pockets of arbitrage opportunities from which to gain. The various combinations of opportunities are explained in this article. (Please note we do not have any call on the AMC’s fund linked here. This is merely for educative purposes).

Identifying opportunities may also mean identifying market-cap segments (large, mid) where the volatility is more. But the fund manager needs to balance that with the margins needed for such stocks.

The fund manager may also rollover positions – that is carry forward the current futures position to the next series. In this process too, he/she may generate some returns.

How arbitrage funds compare with liquid funds

Arbitrage funds India and liquid funds are very different products although their returns are quite comparable. This is because the difference between the spot and futures market is largely a reflection of the short-term interest rate. The additional returns in arbitrage, if any, come from the mispriced opportunities. In the absence of volatility, a liquid fund may provide better returns, pre-tax and they have.

Just look at the following data to understand how arbitrage funds have compared with liquid funds.

For this purpose, we took 3-years of data rolled for 1 day, 1 month, 3 months, 6 months and 12 months between August 2017-20. The following points emerge from such a comparison:

#1 Can generate negative returns

Arbitrage funds India fluctuate a lot on a daily basis and are not suitable for those wanting to park very short term money for days. The probability of negative returns is not nil even over 1 month. In other words, arbitrage funds are not as liquid and as low volatile as liquid funds for 1-3 month periods. You should prefer the safety of liquid funds returns in such cases.

#2 Have lower probability of beating liquid funds

While the risk of negative returns becomes nil in arbitrage funds, the pre-tax returns do not consistently beat liquid funds. The proportion of times arbitrage funds beat liquid fund returns (average returns) over a rolling 6-month period (data for last 3 years), when rolled daily, was just 33%. That means they beat liquid funds just one in 3 times. Over 1-year period, this proportion stands at just 19%.

#3 Pre-tax returns not superior to liquid funds

The rolling-returns graph over the 6 month and 12-month period (above) will also show that barring periods that yields suddenly saw a spike earlier this year, liquid funds have largely stayed ahead of arbitrage funds India even if it were a few basis points more. You will also see that in some 1-year periods like the one ending February-April 2019, the differential in return was well over 100 basis points. The data below will tell you that in almost all cases, the average returns of liquid funds have been higher.

As you can see, arbitrage funds do hold potential to generate higher returns in their best periods. But liquid funds have done better than arbitrage even in their worst periods (i.e., liquid funds’ minimum returns was still higher than that of arbitrage funds’).

#4 Liquid funds generate higher returns consistently

90% of the time, both arbitrage funds and liquid funds have managed to earn returns over 6%, in the period we considered. However, liquid funds travelled the extra mile, making the best of  short-term yields. The data below will tell you that liquid funds managed to generate over 6.5% return a good 80% of the times while arbitrage funds could achieve this only a third of the time.

#5 Tax efficiency is the clincher for arbitrage funds

Despite all of the above data, taxation makes the difference. If you are in the 20-30% tax brackets, the average returns of these categories suggest that arbitrage funds deliver superior post tax returns.

For example (forget the cess), the average post tax-1 year returns for arbitrage funds is 5.7% (at 10% LTCG). For liquid funds the same will be 5.3% if you are in the 20% tax bracket and just 4.7% for the 30% tax slab. Even for periods less than 1 year, this is the case, unless there are periods when liquid funds outperform significantly.

Only those in the 5% tax bracket really have a clear winner in liquid funds. For the others, it does mean you can load up on arbitrage funds – depending on your need. Liquid funds still make for low volatile options. Arbitrage funds can at best be a part of your short-term portfolio.

What’s the scenario now?

As we see it, the yields of liquid funds at around 3.4% (June 2020), clearly make a better case for investing in short-term FDs unless you are using liquid funds to do STPs or prefer liquidity to the lock-in FDs. Liquid funds could also be pulled down by recent regulations that require mark-to-market of securities over 30 days. But the story has not been too pleasant with arbitrage funds either. While fund managers have spoken of improving spreads post the market crash in March, it has been a see-saw for arbitrage funds in recent times. The data below is a simple annualized return of 1-month rolling returns. It will clearly tell you that arbitrage funds too are struggling to deliver.

Please note that the returns have been annualized to make them easy to compare (with FDs as well). They are not an indicator of future performance. Also note that individual arbitrage funds may have far higher returns than the averages given above.

 The arbitrage market, too, was troubled by a few events in the past 3-4 months. According to a note put out by IDFC MF:

  • The increase in margins on stock futures has reportedly caused HNI/retail activity to move away from the futures market to options, thus putting pressure on MFs who by default become large participants.
  • The open interest, which is a key requirement for healthy spreads, reduced again in May 2020. The size of positions in some stocks that entities can take, reduced therefore reducing market participation.
  • Higher FPI participation in index futures than stock futures impacted stock futures liquidity
  • Lower FD rates and short-term rates has meant that both FDs used as collateral and other debt did not earn much nor compensated for the sliding arbitrage opportunities.

Where to invest?

While the market participation has increased since, and individual fund managers  have stated an improvement in spreads, the returns of arbitrage funds are still way below their averages. It would either need a wide market breadth or significant volatility in the market to reverse this scenario.

  • To this extent, arbitrage funds may need a longer time frame (6 months plus), although their risk, post a 1-month holding, has traditionally been almost nil. Hence, for a period of less than 6 months, you need to be wary of taking exposures. And even beyond that, arbitrage funds cannot entirely substitute debt.
  • Liquid funds are unlikely to compete with FDs in the less than 6-month period and may just about manage to stay in line with arbitrage funds, likely trailing some of the best arbitrage funds.
  • For the 6 months to 1-year period, it may be a tug of war between fixed deposit rates and arbitrage funds, depending on the kind of rates your bank offers and whether you are in the 20% or 30% tax bracket. If you’re in the 5% tax bracket, you are better off staying with FDs.
  • For those of you who do not use arbitrage funds, there is no need to seek one unless you have familiarity with the product. It is best to leave existing money in liquid funds (given their liquidity and low volatility) and seek any fresh short-term parking in FDs, until the yields in liquid funds show improvement.

You can check our Prime Funds for various debt options as well as our recommended arbitrage fund. Alternatively, you can register for free to use our MF Review tool to check whether the arbitrage funds you hold have a buy/hold/sell recommendation by us.

To sum up, returns are drying up. Have to bear it for some time, folks!

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