With the Nifty futures quoting at a discount to spot, will it impact the returns on arbitrage funds?

That is absolutely likely and in fact some of the leading arbitrage fund managers like Kotak, Edelweiss and IDFC have even warned their arbitrage fund clients that there could be losses in the near term due to negative arbitrage spreads. Typically, arbitrage entails buying in the cash segment and selling in the futures to lock in the premium. But it can result in losses if it goes into a discount as is the case now. Currently, arbitrage funds manage a total AUM of Rs.55,000 crore which has grown phenomenally in the last few years. Arbitrage funds have a unique advantage because they have the risk and returns of a debt fund but are treated as an equity fund for tax purposes due to the equity holding in excess of 65%. One reason for the negative spreads is the sharp fall in interest rates after the RBI cut repo rates by 110 basis points in the last couple of months due to COVID-19. However, this is most likely a temporary phenomenon and it should still yield good results over a period of 5-6 months.