Even as arbitrage funds offer several benefits, their net impact seems to be all but negated on account of falling returns of these funds. The category average one year rolling returns for arbitrage funds have come down drastically from 8.07% a year back to just 6.38% now. This 6.38% return is significantly lower than the historical return of 7.74% and 8.78% generated by competing products such as liquid funds and ultra short-term debt funds respectively. The historical post-tax returns across tax slabs (see bar graph) show that arbitrage funds have been of some use to only investors in the highest tax brackets.

So, why are returns of arbitrage funds falling? Though the recent stock market sluggishness -- there are more arbitrage opportunities in a buoyant market--is one reason, a sudden spike in inflows to arbitrage funds is primarily responsible for this.

The ability to generate returns comes down when more money chases the same arbitrage opportunities. The assets under management (AUM) of arbitrage funds continue to bulge: The collective AUM of arbitrage funds jumped `5,403 crore in one month, taking the total AUM of arbitrage funds to `31,669 crore in August.

If such inflows continue to arbitrage funds, their return profile will come down. Investors need to make a realistic assessment of the value of arbitrage funds to their portfolio. There's no need to rush in.