Arbitrage funds are giving poor returns. Should we reconsider investing in them?

This week we spoke to Shifali Satsangee, Founder, Funds Veda'a, a mutual fund advisory firm, based in Agra, to find out the common queries of her clients. Often, these questions would be very topical, something that may be worrying many regular in...

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ETMutualFunds.com asks mutual fund advisors and financial planners every week for a list of frequently asked queries by their clients. Often, these questions would be very topical, something that may be worrying many regular investors. The idea is to present the questions and the response of these advisors/planners to those questions for the benefit of our readers. This week we spoke to Shifali Satsangee, Founder, Funds Veda'a, a mutual fund advisory firm, based in Agra, to find out the common queries of her clients. Often, these questions would be very topical, something that may be worrying many regular investors. The idea is to present the questions and the response of these advisors/planners to those questions for the benefit of our readers. Read on.

Financial planner: Shifali Satsangee, Founder, Funds Veda'a, a mutual fund advisory firm, based in Agra.

Questions asked by investors:
1. Arbitrage funds are giving very low returns. Should we continue to invest?

2. Are arbitrage funds risky? We saw some reports?
3. What are the alternative investment options?
4. Should we shift fro arbitrage to debt funds for better returns?

Her response to her clients:
First of all, let's understand one thing clearly: though they are clubbed together with hybrid funds, arbitrage funds are not hybrid schemes. Investors should understand what these schemes do to understand the kind of risk they are taking. Arbitrage funds create positions, explore and exploit arbitrage opportunities that occur due to mis-pricing or the price differential existing between the cash and derivative markets.

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Arbitrage funds are ideal for investors with a short term horizon of one to one and a half years. Such a time period gives sufficient time to allow positions to play out and also provides tax efficient returns. However, investors need to understand that the inherent risks that these funds have is that sometimes there are no spreads or negative spreads available. This can impact the returns of these funds.

For instance, we have witnessed low returns from arbitrage funds recently. This is due to the deep correction we witnessed in March, which caused many stocks to trade at a discount than at a premium to their price. This diluted the returns of these funds. The arbitrage spread turned 10-20 bps negative in March.

Now comes the important point: should you invest or should you redeem? My view is that existing investors should hold their investments and not be in a hurry to redeem since we may see availability of spreads in the near future. No mutual fund scheme can give you good returns throughout the investment horizon. Arbitrage funds are low risk schemes like fixed income funds. They are ideal for investors with a low risk appetite who are looking for better tax-adjusted returns. For investors in the highest tax slab, arbitrage funds are more suitable in the short-term than debt funds.

For new investors I would suggest, weigh your options and decide based on your time horizon, liquidity needs and taxation, and not based on the current spreads. Investors should not chase the high returns in debt funds. It is not a sustainable model to follow. Considering that the interest rates are almost bottoming out and considering the tax efficiency that arbitrage funds offer, it makes a strong case for arbitrage funds.

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