Arbitrage Funds Offer Steady Returns Amid Market Swings

The Investor’s Dilemma

Markets are in flux. Geopolitical events continue to impact commodity prices, fueling inflation fears that keep bond yields elevated, even as central banks signal rate cuts. This disconnect means traditional debt instruments, which investors often turn to for safety, are not performing as expected. “In the last two years, policy rates have been cut in many places, including India. Yet, market yields on debt instruments have risen, already pricing in fear and worries about inflation,” notes Kalpen Parekh, MD and CEO of DSP Asset Managers.

This environment leaves many investors caught between absorbing equity market swings or accepting diminished returns from conventional fixed income. The uncertainty over future interest rate movements adds another layer of complexity, making long-duration funds a riskier proposition.

Income Plus Arbitrage FoFs Explained

Income Plus Arbitrage Fund of Funds (FoFs) offer a structured approach to this challenge. These funds diversify by investing in a mix of other mutual funds, including both debt and arbitrage schemes. The debt component focuses on short- to medium-duration instruments, aiming for steady accrual, while the arbitrage portion capitalizes on price discrepancies in the cash and futures markets.

This dual strategy provides a market-neutral return stream from arbitrage, which remains relatively stable irrespective of broad market movements. Experts highlight that this reduces concentration risk, as investors are not reliant on a single interest rate view. Fund managers actively rebalance allocations among underlying funds, potentially enhancing risk-adjusted returns beyond what a static short-duration fund might offer.

Tax Efficiency and Performance

For investors in higher tax brackets, these FoFs present a favorable tax structure. While gains are taxed at marginal rates if held for under two years, long-term capital gains after two years are taxed at 12.5 percent. This makes them a more tax-efficient choice than pure debt funds for those with a slightly longer investment horizon. Rajul Kothari, Partner at Capital League, points out that the aim is a balance of post-tax efficiency and smoother returns.

Performance data over the past few years shows a pattern of consistency rather than explosive growth. Returns have typically ranged between 5-6 percent annually over one year, 8-13 percent over three years, and 6-12 percent over five years. This stability, particularly in a volatile rate environment, is a key attraction for investors with defined timeframes seeking to mitigate equity risk.