… Curtains down on Classification..Specialty Funds …(contd.)

… Curtains down on Classification

Specialty Funds …(contd.)

The Arbitrage / Derivative Fund is the closest any mutual fund scheme in India can get to a Hedge Fund. SEBI has not allowed any AMC to float a Hedge Fund in India. Presently, there are arbitrage funds from JM (JM Equity & Derivative and JM Arbitrage Advantage), Kotak (Kotak Cash Plus), Prudential ICICI (Prudential ICICI Blended Plan),UTI Mutual (UTI Spread) and SBI (SBI Arbitrage Opportunities Fund).

A fund manager would buy the equities in the capital market and sell it in the futures market, making good the difference. This is how it works: if company ABC's stock is trading today at Rs 30 per share and is expected to rise over the next month, the one-month futures price of the stock will be higher, say, Rs 35. A fund manager would then buy the underlying stock and sell it in the futures market, making a gain of Rs 5. When settlement day arrives, it is irrelevant whether the share price of ABC Ltd. has risen or fallen. One would still make the same amount of money. This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place - buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, the investor earns the spread between the purchase price of the equity shares and the sale price of futures contract.

The equity arbitrage fund is market neutral; hence, it will not be affected by temporary fluctuations in the Sensex. It does sound like a very simple and effective way of making money in the market. If only life were indeed that simple…

The first hurdle is the presence of arbitrage opportunities. In a given period of time, the market may or may not provide any meaningful arbitrage opportunities that hold the key to the amount of money the fund will earn. No doubt, the fund management team has sophisticated softwares that flag such mispricing the moment it occurs and is extra vigilant in identifying such opportunities.

Secondly, there is the issue of costs. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail the payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings.

Derivative Funds always yield limited returns. However, it is the risk free nature of the returns that is the USP of the product. After all, the problem that most investors have with entering into the equity market is the lack of assured risk free returns. Arbitrage/Derivative Fund is a product that gives you exactly that.

Mutual funds with tax benefits

Mutual Funds by their very nature are not tax saving instruments but investment products that may offer tax concessions. But the question is whether these can be looked at as tax saving instruments?

For an Equity Fund:
· Long-term capital gains are tax-free
· Short-term capital gains are taxed at only 10%
· Dividend is not subject to dividend distribution tax
· Redemption of units is subject to a Securities Transaction Tax (STT) of 0.25%.

Equity Linked Savings Scheme (ELSS) are special Equity Funds, which have to invest at least 80% of their corpus in equity and offer a tax benefit over and above those mentioned above. Any investment in an ELSS fund offers Sec. 80C deduction i.e. the amount invested is deductible from taxable income. However, Sec. 80C has a cap of Rs. 1 lakh and presupposes a lock-in of 3 years. Sec 80 C covers principal on housing loan, PF, pension plan, life premiums, so only what is left after that can give a tax benefit if invested in ELSS.

ELSS funds, in general, have been found to out-perform their Equity Diversified counterparts. This happens essentially as the fund manager has the money at his disposal over the long-term without having to cater to everyday redemptions. Therefore, regardless of the tax benefit, even investing over Rs. 1 lakh may be an idea to consider.

Socially Responsible (Ethical Funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience. Such funds are not common in India.

In developed countries like the U.S.A there are funds to satisfy everybody's requirement, but in India only the tip of the iceberg has been explored. Innovation, they say, is the key to success. So, in the universe of mutual fund schemes, new ones keep passing by but it is those that stand apart that catch the discerning investor's eye.