FUND FLAVOUR
March 2011

To the brink and back again

"It was the best of times it was the worst of times." - Charles Dickens

No other mutual fund category has seen such wild swings in fortunes as the Indian Derivative Funds over the last seven years. Derivative/Arbitrage Funds made a small beginning when they were launched in 2004. As the world was rocked by the financial crisis, these funds turned in a spectacular performance. When the equity market tanked in 2008, arbitrage funds came up with a good show moving up 8.5% in the year. This was followed by a period of lull before the current display of effervescent performance backed by a volatile market. Arbitrage funds are back in the limelight with the category moving up in the performance charts in the three and six months’ time frame. With Sensex climbing all the way up to 21,000 points before slipping to 18,000 levels, these funds that thrive on volatility started gaining after a long gap. Arbitrage funds tend to do well in a turbulent market and are among the top-5 best performers in the past six months.

Arbitrage Funds Demystified

Simply put, in an arbitrage fund the buying and selling of stocks in cash and futures market happens simultaneously. Arbitrage takes place when the price of the same asset is different in two markets. This way, a fund manager would be able to earn risk-free profits by buying from one market at a lower price and selling it simultaneously in a different market at higher price. Typically, arbitrage funds cash in on the disparity between cash and futures markets. The ultimate objective of these funds is to hedge positions completely and identify stocks where spreads are higher. Identifying spreads and order execution is the key. Arbitrage funds can be useful when the markets are volatile and the returns from debt funds also remain on the lower side. Unlike debt funds, where there is a fair element of certainty about the actual returns as they invest mostly in bank CDs now, you would not be able to predict the gains from arbitrage funds. As these funds resort to heavy trading to maximise gains, expense ratios are also higher. These funds typically target opportunities that pay more than short-term debt. So monitoring the performance of these two categories would help you in taking an appropriate call. While you cannot expect mind-boggling gains, you can get risk-free returns.

Risk-free …

Arbitrage funds perform best in a volatile market. The objective of an arbitrage fund is to provide risk-free returns. Fund managers can hedge their risks by going long in the cash market and short in the futures market. Arbitrage funds are the safest options as they always hold hedge positions and toggle between cash and the futures options. In that sense, their risk profile is lower. At no point will these funds perform badly because of their hedge positions, except when the markets are either steadily moving up or moving down.

… or not quite?

Though arbitrage funds are referred to as 'risk-free' investments, this is not strictly true because there is some risk in the availability of arbitrage opportunities and their timing. Arbitrage funds depend heavily on the availability of arbitrage opportunities in the market. A long bear phase may create problems because the arbitrage strategy of buy stock, sell future will not work if the future price of the stock is trading at a discount to its spot price. On the date of expiry, when the arbitrage is to be unwound, the stock price and its future contract may not coincide. There could be a discrepancy in their prices. Thus, there is a possibility that the arbitrage strategy gets unwound at different prices, leading to a higher or lower return. In addition to scarce arbitrage opportunities, margins tend to be low and expense ratios high as such funds trade heavily. Arbitrage funds are also impacted by lower liquidity in the spot/future segment. Future contracts are always traded in lots i.e. one lot of a future contract of a particular stock will have multiple shares. If an arbitrage opportunity arises, the fund manager will have to buy the lot shares of the company from the stock market and sell one lot of its future contract.

Tax-efficient …

Arbitrage funds are, however, tax efficient. Since stocks occupy more than 65% of their portfolio, they are treated as equity mutual funds for taxation purpose. The dividend and long term capital gains from these funds are tax free.

Mutual funds come to the rescue of those who intend to take the arbitrage route but lack the expertise. Arbitrage funds aim to make risk-free profits, by capturing the price differentials across markets arising out of the inefficiencies of the markets. You can invest in such funds with a minimum of Rs 5,000. The ideal time horizon for investing in arbitrage funds is between one to two years. The expected rate of return can be slightly above that offered by the bank fixed deposits of similar tenure. An ideal avenue to surf through during volatile times…