Among the innovations in the mutual fund industry the one that ranks high in the confused investor’s list is ‘Arbitrage Funds’. It is easy to understand why. Ask any investor in arbitrage funds how arbitrage works and his response is likely to be – I don’t understand arbitrage but so long as the fund manager knows what he is doing and gives me a decent return I am okay with it.

Investing in something you don’t understand can prove perilous. While relatively inexperienced investors may venture into an investment without understanding its dynamics, seasoned investors usually know where to draw the line. Investor guru, Warren Buffet kept an arm’s length from technology stocks because he didn’t understand the sector’s dynamics. The tech meltdown in 2000 vindicated his stand.

In terms of complexity, few investments rank higher than arbitrage funds. This is more than apparent when one speaks to all the parties involved over here i.e. a) those who launched the fund (even the sales staff of the fund house are vague when discussing arbitrage funds), b) those who distribute the fund and c) those who invest in it. One round of discussion with these three entities and one can’t help wondering how something as confusing as arbitrage funds can be so popular.

 Without delving into how arbitrage funds work (we hope our article unravelled that for you), let’s evaluate whether their performance justifies the risk investors take by investing in them.

  Arbitrage Funds: Modest returns

Arbitrage Funds	NAV (Rs)	6-MTH	1-YR
UTI Spread (G)	11.74	4.52%	9.16%
Lotus India Arbitrage (G)	10.97	4.45%	8.92%
ICICI Pru Blended A (G)	12.70	4.38%	8.90%
JM Arbitrage Fund (G)	11.67	4.19%	8.74%
SBI Arbitrage Opp (G)	11.47	3.96%	8.48%

(Source: Credence Analytics. NAV data as on May 23, 2008.)
(The growth option of the leading five arbitrage funds have been considered for the analysis. All the arbitrage funds are predominantly invested in derivatives/equities.)

By any yardstick the returns offered by arbitrage funds are not at all impressive. In fact, they are so tame that one begins to wonder why there is so much investor interest in them. Why do we find the returns on arbitrage fund tame? The following table answers that question.

  Floating Rate Funds: A superior showing

Long-Term Floating Rate Funds	NAV (Rs)	6-MTH	1-YR
Kotak Floater LTP (G)	12.89	4.26%	9.17%
HSBC Float LTP (G)	12.65	4.27%	8.94%
HDFC Float LTP (G)	13.62	4.62%	8.87%
Birla Float LTP (G)	13.61	4.42%	8.76%
Tata Floater (G)	12.13	4.25%	8.60%

(Source: Credence Analytics. NAV data as on May 23, 2008.)
(The growth option of the leading five long-term floating rate funds have been considered for the analysis.)  

In case you are wondering why we are comparing debt funds with arbitrage funds (which are equity-linked), it's because prudence demands that an investment avenue should be evaluated in terms of its risk-return trade off. Hence, while evaluating a risky investment option (like an equity-oriented one) investors must first compare it with a lower risk investment option (like debt-oriented funds) to ascertain if it is worth taking on the additional risk. Incidentally, even arbitrage funds benchmark their performance against the liquid fund index.

Clearly, returns on floating rate funds are competent enough and as a category they have outperformed arbitrage funds. However, on a post-tax tax basis, returns on arbitrage funds are a little higher.

FMPs vs Arbitrage funds
However, if liquidity is not an issue for the investor, then there is one debt fund category that can outperform arbitrage funds even on a post-tax basis. Until a month ago, FMPs (fixed maturity plans) were giving a post-tax return upwards of 9%, which is comparable to the returns on arbitrage funds. Although, the yields on FMPs have fallen a bit since, in our view even with a lower post-tax return (of around 8.5%), investors are better off investing in an FMP rather than an arbitrage fund.

FMPs are low risk (particularly if the investment is made in highest rated paper) and the return, albeit indicative, is virtually assured. Arbitrage funds on the other hand take on risk and their performance is historical and hence there is no certainty that they will clock a similar return in the future (especially if arbitrage opportunities dry up).

Points to note
Whenever there is a spurt in arbitrage opportunities, the short-term performance of arbitrage funds begins to look up. Fund houses start talking about it in their communication to distributors/investors. In the midst of the hype, it is important for investors to step back and note some important points with regards to arbitrage funds.

1) Arbitrage funds are meant to be a long-term investment opportunity so a short-term spurt in arbitrage opportunities means very little. Fund managers will be the first to admit that attractive arbitrage opportunities are not easy to come by week after week, month after month.

2) If investors choose to remain invested for a shorter time frame (of less than a year) to capitalise on those limited arbitrage opportunities, they will incur short-term capital gains (assuming they have earned a profit on the arbitrage fund), which could rob them of a part of the gains. At present, short-term capital gains on equities are taxed at 15%.

3) More than anything else, arbitrage funds enjoy an edge over debt funds mainly because of the tax benefit. Long-term capital gains on debt funds are taxable at 10% without indexation or 20% with indexation (depending on which option is lower). On the other hand, long-term capital gains on equity funds (of which arbitrage funds are a subset) are subject to STT (Securities Transaction Tax) at 0.25%. Assuming that returns from arbitrage funds are the same as debt funds (like FMPs or floating rate funds) or even if arbitrage funds offer a slightly lower return, the tax advantage of investing in equities means that investors in arbitrage funds have a significant edge over their debt fund counterparts. But as we have shown, in practice debt funds often do better than arbitrage funds so the tax benefit on arbitrage funds is not very significant in the final analysis.

The question that needs answering is whether investing in arbitrage funds is worthwhile only for the tax advantage. Our comparison of arbitrage funds with their debt fund peers (like FMPs and floating rate funds) proves that it is not worthwhile. Returns on both options (arbitrage funds and debt funds) are comparable and the tax benefit on arbitrage funds does not make it a compelling enough investment option.

The verdict on arbitrage funds is clear. Not only should investors avoid investing in them because they are confusing, but the returns offered by them do not compare well with those offered by lower risk options. What this tells investors is that arbitrage funds do not reward investors for the higher risk taken by them and the tax advantage of investing in arbitrage funds is not a good enough reason to invest in them ahead of FMPs or floating rate funds.

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