Monday, March 05, 2012

March 2012

High returns at low risk

Want high returns at low risk? Try arbitrage funds. These funds try to cash in on the price variation of the same security in different markets; they go long in the cash market, short in the futures market and behave like a debt fund. Theoretically, these funds benefit from the arbitrage opportunities arising out of price differences between the equity and derivatives segment of the stock market. But this does not ensure returns. The real attraction of arbitrage funds is in post-tax returns. How do they work? Suppose a stock is trading in the cash market at Rs 400 whereas in the futures market its price is Rs 410. An arbitrage fund will buy the stock in the cash market and simultaneously sell it in the futures market, locking a gain of Rs10. On the settlement day, it will reverse the transaction. If the price of the stock goes down, so will the price of the futures. No matter what the price of the stock, the fund will make a profit of Rs 10 per share. On the date of expiry, when the arbitrage is to be unwound, the stock price and its futures contract of the current month coincide. Arbitrage funds appear to be one of the best options in a volatile market for investors who wish to invest in a low-risk portfolio and yet earn decent returns.

The cutting edge

Arbitrage funds enjoy an edge over debt funds mainly because of the tax benefit. No tax on the gains of arbitrage funds in the long term (one year or more) and only 15% tax in short term (less than a year). The mandatory 65% in equity needs to be maintained by the fund manager. Otherwise, they would not qualify for the equity tax benefits. Assuming that returns from arbitrage funds are the same as debt funds or even if arbitrage funds offer a slightly lower return, the tax advantage gives arbitrage funds a significant edge over their debt fund counterparts.

Arbitrage strategy reduces risk and delivers decent risk-adjusted returns in comparison to other short-term debt funds, even in times of market volatility.

The ‘hidden’ risks

Arbitrage funds depend heavily on the availability of arbitrage opportunities in the market. Lack of such opportunities can sometimes dampen the results.

Sometimes, when the futures contract expires, the price of the stock in the cash and futures segments can have a slight difference in their prices. As a result, profit will be affected.

Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs can chop some of the earnings of the fund.

Crushed by competition?

The total average assets under management (AAUM) of 15 arbitrage funds in India dropped to Rs 955 crore as of December 31, 2010, from Rs 4,105 crore as of April 31, 2010 according to data provided by Value Research. The key reason (behind the sharp drop in assets of arbitrage funds) is the lack of arbitrage opportunities, given the increased volume in derivatives, especially options, and also higher returns by liquid funds in the last few months. The arbitrage fund category has returned almost 6% in 2010 and roughly 4.5% in 2009 as against 8-9% by fixed maturity plans (FMPs) and 8.5% by liquid schemes. Between 2006 and 2008, this category fetched average returns of 7-8% with the better performers aiming at 10-11%, higher than returns from money market products. In addition to higher returns, the better tax treatment of arbitrage schemes compared to fixed income also lured investors to this product in the past. Arbitrage schemes of domestic mutual funds have fallen out of investors' favour in the past 18 months. Assets under this category have fallen 82% since January 2010 to Rs 300 crore as dwindling arbitrage opportunities and the higher yield on fixed maturity plans (FMPs) and liquid funds have squeezed returns in the past two years, prompting investors to shift money to short-term debt or money market products. Tax advantage is getting eroded in a situation of rising inflation and high bank interest rates. An average return of 6% (tax-free) from arbitrage funds is not better than the fully taxed, but fixed and safe return of 9% offered by banks currently. But this is likely to be a temporary phenomenon.

Making volatility work

An investor can consider including these funds in his core portfolio anytime without worrying about where the markets are heading. While the equity investments can pull the overall portfolio returns, arbitrage funds tend to bring a sense of steadiness to them. The returns generated by arbitrage funds are not too high but the ‘risk-free’ nature is their ‘high point’. The ideal time horizon for investing in these funds is one year or more to avail the tax advantage. Whether the markets zoom ahead or fall backwards, they will always continue to surprise us, as ‘capricious’ is its inherent nature. Why not then, ‘ride on volatility’ with arbitrage funds and make volatility work by gaining from the opportunities lying in the different moods of the market?

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