Recent monetary policy decisions in both the United States and India indicate a shift towards easing interest rates. The US Fed has been signaling that there is a need to keep the policy rate accommodative and is open to rate cuts if the data supports this.
In its latest summary of economic projections, Fed members indicated easing of rates by 50 basis points (bps) in calendar year 2025. The Reserve Bank of India (RBI) reduced its key interest rate by 25 bps to 6.25% in February, its first rate cut since 2020, as it looked to support economic growth amid easing inflation.
Meanwhile, equity market volatility is being fueled by geopolitical tensions, slowing economic growth, and uncertain corporate earnings. As a result, investors are increasingly seeking alternative strategies that can balance risk and returns.
How arbitrage funds work
Arbitrage funds capitalise on price discrepancies between the cash and futures markets. Fund managers buy securities in the cash market and sell equivalent positions in the futures market, locking in risk-free profits from these differences. Typically, these funds allocate about 65-75% to cash future arbitrage opportunities and the remaining to debt and money market instruments.
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The pricing of futures contracts incorporates the cost of carry, which includes the risk-free rate, often benchmarked to instruments such as short term debt issuances. As interest rates decline, the spreads between cash and futures prices tend to narrow, potentially reducing returns from arbitrage strategies. However, arbitrage funds benefit from favourable tax treatment. They’re classified as equity investments for taxation, and thus eligible for 12.5% long-term capital gains tax if held for more than a year.
Market volatility plays a crucial role in determining arbitrage opportunities. During periods of heightened volatility, price discrepancies often widen, creating more profitable arbitrage scenarios. Conversely, in stable or declining interest rate environments, these opportunities may be less frequent. Investors should note that while arbitrage funds are generally considered low-risk investments, they offer a balanced approach for risk-averse investors, especially when interest rates are in transition.
Medium- to long-term debt funds benefit from interest rate cuts
Where interest rates are expected to decline, medium to long-term debt funds become attractive due to potential capital appreciation. These funds invest in longer-duration fixed-income securities, which gain value as yields fall, providing mark-to-market gains alongside regular interest accruals.
However, the tax treatment of debt funds is less favourable than that of arbitrage funds. Gains from debt funds are taxed at the investor’s marginal income tax rate, which can significantly reduce post-tax returns, especially for those in higher tax brackets.
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The sensitivity of these funds to interest rate changes is measured by duration – a higher duration implies greater price responsiveness to rate fluctuations. Investors should carefully assess their risk tolerance and investment horizon before allocating to medium or long-duration debt funds. While these funds can deliver substantial returns during rate cut cycles, they may underperform when rates stabilise or begin to rise.
Income plus arbitrage fund of funds
In light of the 2024 budget amendments, non-debt-oriented fund of funds (FoFs) have distinct tax advantages. An income plus arbitrage FoF typically allocates around 60-65% of its portfolio to debt funds and the remaining to arbitrage funds. The allows returns to be taxed at 12.5% if held for more than two years.
These FoFs also offer the flexibility to dynamically manage the debt portion based on the fund manager’s outlook on interest rates. Unlike direct investments in individual debt funds, where each switch can trigger tax liabilities, FoFs can rebalance internally without immediate tax consequences for the investor. Recognising these benefits, Kotak was the first to launch such a fund, positioning it as a tax-efficient alternative for investors seeking a combination of debt stability and arbitrage-driven returns.
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For investors seeking professional management without the complexity of maintaining multiple fund positions, these vehicles offer convenience through a single-window investment approach. The composite structure also allows managers to capitalise on tactical opportunities across debt and equity arbitrage (cash & futures), potentially enhancing risk-adjusted returns over interest-rate cycles.
Conclusion
An income plus arbitrage FoF aims to deliver enhanced accruals and potential long-term capital appreciation by integrating debt-oriented mutual funds with equity arbitrage strategies. With anticipated rate cuts of 25-50 basis points in the current cycle, such funds are well-positioned to optimise post-tax returns, making them a prudent choice for investors with an investment horizon exceeding 24 months.
Deepak Agrawal is chief investment officer for debt and head of products at Kotak Mahindra Asset Management Company.
