FUND FLAVOUR

March 2013

The long and short of …

For most investors the darkest deterrent of a stock market is “volatility”. Here is a fund, that offers cushion against market ups and downs in the near to medium term. If you are an investor who can take moderate to low risk, Arbitrage Funds could serve you in this regard. An arbitrage fund follows a strategy of buying and selling similar and equal securities simultaneously from at least two different markets. It takes advantage of the mispricing between two markets thus hedging against risk. The profit would be the difference between the prices of the instrument in different markets.

  

Let us consider the stock of ABC Ltd, which is being traded in the equity market as well as the derivative market at Rs. 500 and Rs 520 respectively. The arbitrage transaction could involve buying ABC Ltd. shares at Rs 500 per share in the equity market. At the same time, share of ABC Ltd. would be sold in the futures market, at Rs 520. On the expiry date of the futures contract, the price of the equity shares and the stock futures, tend to coincide. These two transactions can be offset by buying the contract in the futures market and selling the shares in the equity market. Suppose, on this date, the share price is Rs 530, a profit of Rs 30 (Rs 530 - Rs 500) per share is made in the equity market and a loss of Rs 10 (Rs 520 - Rs 530) is made in the derivative market. The net gain is Rs 20. If the share price falls to Rs 470, a loss of Rs 30 in the equity market and a profit of Rs 50 in the futures market are made. Again, the net gain is Rs 20. Irrespective of whether the share price of ABC Ltd. has risen or fallen the profit remains the same. As both the buying and selling transactions offset each other, they are not affected by market movements.

…beating market volatility with Arbitrage Funds

The volatility in the markets is something Arbitrage funds breed on. This is a favourable time for investors of arbitrage funds given the increased volatility in the stock market. Besides, fund houses have installed computerised systems and processes, which help them spot arbitrage opportunities in advance.

AUM abatement to the rescue

Another factor that is currently working in favour of investors is the fall in assets under management (AUM) in most arbitrage funds over the years. How does this help the funds' performance? Arbitrage opportunities are limited, so the more the number of players, stronger the competition to take advantage of the opportunities, which, in turn, dilutes the returns of the funds. During their heyday in 2006-08, arbitrage funds generated better returns than debt products and this attracted large sums of money into the category. Fund houses also launched new arbitrage funds, increasing the competition. Since all arbitrage funds were fighting for the same set of opportunities, the category performance suffered and investors deserted the funds. This resulted in the average AUM of several schemes falling below Rs 1 crore. Currently, there are only nine arbitrage funds with an AUM of more than Rs 25 crore, with Kotak Equity Arbitrage Fund having the largest corpus of Rs 125 crore.

Will history be repeated? Yes it may. If money starts pouring into these funds and they grow to much bigger levels, the performance of arbitrage funds could suffer. So, if you plan to invest in an arbitrage fund, you should keep a close watch on the category size. You can enter these funds anytime and not worry where the market is headed. Since these funds invest predominantly in equities, they are treated like equity-oriented mutual funds and have identical tax treatment. They attract a lower short-term capital gain tax of 10% and become completely tax-free if you hold them for a period exceeding one year. Arbitrage funds are best equipped to deliver in volatile times when there is enough arbitrage opportunity.

Short-term…shines

There are 15 funds in India that use arbitrage strategies to generate returns. With an average return of nearly 9% in the last one year, arbitrage funds outdid diversified funds in a volatile market, although their long-term performance lacks lustre. Over the last one-, three- and five-year periods, the average returns generated by arbitrage funds were 8.15%, 7.08% and 7.02% respectively. Funds such as ICICI Prudential Blended Plan - Option A, IDFC Arbitrage - Plan A (Regular), JM Arbitrage Advantage, Kotak Equity Arbitrage, Reliance Arbitrage Advantage, and SBI Arbitrage Opportunities returned more than 9% over the last one year, taking advantage of market volatility.

A mixed bag

Though marketed as risk-free investments by most fund houses, investors’ reactions have been mixed. Theoretically, these funds use the price difference between the equity and derivative markets to generate results. However, in reality, like all mutual funds, arbitrage funds have managed to generate high profits, mostly when the market has been in a rally. For debt fund investors, arbitrage funds could prove to be a better option due to its tax benefit. No investment is totally risk-free. Understand the risks involved before taking the plunge.