Fund manager insights: Sailesh Jain of Tata MF explains how arbitrage funds work for investors

In an environment where investors are increasingly seeking stability without compromising on efficiency, arbitrage funds have steadily carved out a space for themselves. Positioned between equity and debt, they aim to offer relatively stable, tax-efficient returns while maintaining a largely neutral market risk.

In an exclusive conversation with Upstox, Jain breaks down how arbitrage funds really work, why flexibility and judgment matter more than rigid formulas, and what investors can realistically expect from the fund across volatile, calm, bullish, and bearish markets.

To put it simply, we keep adjusting our percentage allocation to arbitrage depending on market conditions and situations. For instance, our arbitrage positioning has gone as low as around 66% at certain points and as high as 80%. Currently, it is around 76–77%. This is a dynamic and continuous process. There is no fixed or scientific number. It keeps changing, even within a month, by 1% or more. It is more of an artistic approach, driven by the fund manager’s judgment, rather than a rigid formula.

The last two years have been very good for arbitrage funds, and I personally believe that the next one to three years will also be an ideal scenario for arbitrage. We are in a low-interest-rate environment where debt products like liquid and ultra-short funds are more impacted by interest rate movements compared to arbitrage funds. This is why arbitrage funds are likely to continue outperforming liquid and ultra-short funds on a post-tax basis by at least 50 to 100 basis points. While it is difficult to give absolute numbers, it is fair to say that this fund should continue to outperform liquid and ultra-short funds on a post-tax basis.

It is important to look at both absolute and relative returns. Relatively, this fund should be compared with liquid and ultra-short funds. Given market volatility, equity market buoyancy, and tax advantages, arbitrage funds should continue to outperform liquid and ultra-short funds by around 50 to 100 basis points.

On an absolute basis, returns in the range of 6% to 6.5% are achievable, although this may change with market conditions. Defining good, normal, or below-average returns is difficult, but as long as the fund consistently outperforms comparable debt funds like liquid and ultra-short funds, it remains a strong investment option.

One major misconception is around the use of derivatives. Investors often fear derivatives, but in arbitrage funds, derivatives are used purely for hedging.

These funds are completely hedged from inception. For every long equity position, there is an equivalent short position. There is no price risk in arbitrage funds. Returns are generated by capturing the spread between cash equity and futures prices.

During volatile markets, every situation is different. What becomes critical is selecting the right market capitalisation, sector, and stocks where volatility is expected to be high. This allows the fund to enhance returns through entry and re-entry into stocks where spreads are trading higher or lower.

I don’t believe there is any significant underestimated bias. The mutual fund industry is now well understood and well discovered, with industry assets close to ₹4 lakh crore. Acceptance and adoption of these funds have increased significantly over time.

The fund makes money from the difference between futures prices and cash equity prices. In bullish markets, futures premiums generally expand, which helps generate higher returns. In very bearish markets or sharp crashes, such as during COVID, spreads compress significantly, making it harder to generate returns.

However, such periods are usually short-lived. Fundamentally, arbitrage is linked to interest rates, and as long as interest rates are positive, the fund should logically continue generating returns.

Arbitrage funds make sense at almost all times. Their absolute returns are similar to or better than fixed deposits, they offer tax advantages, and they provide liquidity. Taxation is lower compared to FDs, and after a 30-day exit load period, investors can exit freely.

While liquid funds may have slightly better liquidity, a portion of money from liquid funds and FDs should ideally be allocated to arbitrage funds.

The longer the investment horizon, the better. However, even a holding period of two months or more is suitable for arbitrage funds.

Since positions are fully hedged, there is no price impact on the fund during market crashes. In fact, increased volatility can sometimes enhance returns, as futures may trade at discounts, leading to better realisation at expiry or before.

Investors expecting equity-like returns should avoid arbitrage funds. These funds are better suited for investors with surplus cash currently parked in savings accounts, FDs, liquid funds, or ultra-short funds.

Investors should avoid tracking daily NAVs. It is better to look at performance every month, preferably from expiry to expiry, as that provides a clearer picture of returns.

Investors often focus on short-term performance. Arbitrage funds should be evaluated based on consistency across market cycles – when markets rise, fall, or remain flat. Consistency is more important than short-term spikes in returns.

Investors often chase funds that have performed well in the short term. Instead, they should focus on consistency of performance over time and the track record of the fund manager. A consistently performing fund across different market conditions is a better investment choice.