Mutual funds: What’s making arbitrage funds a hot buy

Most investors expect market volatility due to lockdowns in various states, demand slowdown and wholesale price inflation and manufacturing PMI showing stress.

With volatility in the markets and concerns over the intense second wave of the pandemic and its possible impact on the economy, mutual fund investors are increasingly looking at hybrid schemes. From January to April this calendar year, hybrid schemes reported net inflows of Rs 21,696 crore as compared to a net outflow of Rs 29, 203 crore from July to December 2020. In hybrid schemes, investors are opting for arbitrage funds, balanced advantage funds, multi-asset funds and dynamic asset allocation funds as compared to pure equity funds.

In fact, equity-oriented mutual funds saw a drop in net inflow to Rs 3,437 crore in April 2021 as compared to a strong net inflow of Rs 9,115 crore in the previous month. Before March 2021, the segment witnessed net outflows for eight consecutive months. Investments through systematic investment plans saw a drop in April at Rs 8,590 crore against Rs 9,182 crore in March as investors preferred to stay on the sidelines until more clarity emerges around the impact of the second wave of the pandemic on the economy.

Hybrid category gains
In April, the hybrid fund category reported a net inflow of Rs 8,641 crore led by arbitrage funds at Rs 7,245 crore, followed by balanced advantage fund at Rs 1,700 crore, balanced hybrid funds at Rs 184 crore and multi-asset allocation funds at Rs 26 crore. However, dynamic asset allocation funds reported net outflows of Rs 501 crore.

Hybrid funds come with different combinations of equity and debt investments and investors can select funds according to their risk appetite. By investing in hybrid funds, individual investors can create a balanced portfolio and earn regular income along with capital appreciation in the long-term. For risk-averse investors, hybrid funds are a better choice as they give higher returns than debt funds and are not risky as equity funds. So, in a situation when debt funds are giving lower returns and equity funds turning risky, savvy investors are putting money in various hybrid category funds depending on their risk appetite.

An equity-oriented hybrid fund invests minimum 65% of its total assets in equity-related instruments and the rest in debt-related instruments. On the other hand, a debt-oriented hybrid fund will invest a minimum of 60% of its total assets in fixed-income securities like bonds, debentures, government securities and the rest in equity. However, balanced funds invest a minimum of 65% of their total assets in equity and equity-related instruments and the rest in debt.

Arbitrage funds
Most investors expect market volatility due to lockdowns in various states, demand slowdown and wholesale price inflation and manufacturing PMI showing stress. Between January and April, arbitrage funds reported net inflows of Rs 20,601 crore, the bulk of the total net inflows of Rs 21,696 crore received by hybrid category.

In arbitrage funds, the fund manager simultaneously buys shares in the cash market and sells them in futures or derivatives markets and the difference in the cost price and selling price is the return that the investors earns. The price of a stock in the derivatives market quotes at a premium to its price in the cash market. This allows for an arbitrage opportunity which such funds attempt to encash by buying a stock in the cash market and selling it in the futures market, thus earning the differential premium between the two prices.

As arbitrage funds benefit from the difference in price between the cash and futures market and the spread moved up to 70 basis points in April, individuals are investing aggressively in such funds now. Moreover, many are staggering their equity investments by using arbitrage funds as they provide higher post-tax returns as compared with liquid funds. Arbitrage funds can give reasonable returns to those investors who can understand it and then make the most of it.