Arbitrage fund returns closely track short-term risk-free market interest rates. This is because arbitrage opportunities exist when there is a spread between cash and futures markets which is similar to or better than short-term risk-free market interest rates. Any yields that are substantially higher than short-term market interest rates, get quickly arbitraged away - leading to most Arbitrage transactions taking place at close to current prevailing short-term risk-free market interest rates.

Between 2020-22, market interest rates fell sharply as central banks slashed rates to support the economy post-COVID. The repo rate dropped from 6.5% to 4.00%, and this decline affected all low-duration low-free instruments, including liquid funds, short-term bank deposits, and arbitrage funds. Since arbitrage returns are directly tied to these rates, it’s no surprise that arbitrage funds delivered weaker returns in this period.

Essentially, lower yields on Arbitrage funds between 2020-22 are a direct result of the very low market interest rates over this period, and returns are commensurate with returns earned in other very low-risk, highly liquid short-term fixed income investment options.

Key takeaway: If you’re investing in arbitrage funds, their likely returns will always be dictated by prevailing short-term market interest rates.

For a deeper dive into arbitrage fund taxation and post-tax yields, check out our blog: Arbitrage Funds – Why Post-Tax Yields Are Superior to Debt Funds.