FUND FLAVOUR

March 2014

 

Is there any mutual fund in the market with features like safety combined with better taxation? Yes. It is called Arbitrage Fund. Arbitrage fund is an equity based mutual fund which provides consistent performance like debt mutual funds, but is taxed like equity mutual funds. It means, you are taking less risk akin to debt funds but getting better taxation benefits of equity funds. Effectively, they provide consistent returns like debt funds, and do not fluctuate much like equity funds do when the stock market goes up/down. How do arbitrage funds provide consistent returns and are still equity funds? Let us understand the concept of how arbitrage funds actually work.

The long and short of an Arbitrage Fund

Arbitrage funds generally invest 65% to 90% in derivatives and the remaining 10% to 35% in money market debt instruments or equity, depending on the scheme plan. These funds invest in “arbitrage opportunities” in the market. The opportunities occur where there is a difference in the prices of a share at two different times/locations. It can be a difference in share prices at a point in time in BSE and NSE exchanges, or it can be a difference in the prices of the stock in spot and F&O market. When such an opportunity occurs (and it almost always does), these funds buy and sell the shares at the same time in two different markets. They buy the share from where it is cheaper and at the same time sell it where it is expensive. This way, they earn some money and this money is called the arbitrage money. As they buy and sell at the same time, there is not much risk involved. Even if the stock prices go high or low, it does not make any difference to them because they have already earned their money. This is the reason why these mutual funds are able to offer consistent performance over time.

The rationale

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

·       Taxed as equity funds, they offer a tax advantage over income funds.

On the flip side

·       Though arbitrage fund can be purchased any time, redeeming units happen only on the last Thursday of the month, i.e. on the futures expiry date. For redemptions before that, money will be paid out only on or after that date.

·       Meaningful arbitrage opportunities in the market are not easily available. The fund house will have to be vigilant in identifying such opportunities.

·       A few funds invest in stocks at times when no lucrative arbitrage opportunities are available. In such cases funds are exposed to the same risks as a diversified equity fund.

·       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 affect profits.

Pick the chaff from the grain

Arbitrage funds have been in existence in India for nearly a decade. Erstwhile Benchmark Mutual Fund (now Goldman Sachs Mutual Fund) was the first mutual fund to launch an arbitrage fund. Today, there are 15 funds in India which use arbitrage strategies to generate returns. However, it is important that you carry out basic due diligence before selecting an arbitrage fund. To begin with, you need to differentiate between pure arbitrage and arbitrage plus funds. In the former, the equity component is completely hedged while the latter can take unhedged positions and thus carry a higher risk. Only eight of the 15 arbitrage funds can be considered as pure arbitrage funds. You must also ensure that your arbitrage funds maintain an equity exposure of at least 65% to enjoy the tax benefits of an equity fund. While choosing arbitrage funds, you also need to look at the exit loads which range from 0.25% to 1% for exits varying from 7 days to 1 year.

Make hay …

After remaining relatively stable for several months, the stock market volatility is picking up again. Though the investors are affected by the turbulence, it has turned into an opportunity for arbitragers. Arbitrage trading is a skilled technique and not all retail investors can do it. However, they can resort to it using the arbitrage funds available in the market. As a category, these funds have generated over 9% annualised returns in the recent past, and with the increase in volatility, the returns may be higher in the coming months. Further, interest rates have also been rising, and that is giving rise to more arbitrage opportunities. Mid-caps form a significant chunk of an arbitrage fund’s portfolio these days. For example, nearly 26% of SBI Arbitrage Opportunities’ top equity holding, which forms a little over 50% of the fund’s portfolio, is in mid-cap stocks. Arbitrage funds are good products to invest with a horizon of six months to a year. Avoid looking at its NAV daily. At the same time, do not invest and forget. This is because the arbitrage opportunity can dry up as it did a few years ago. Besides the changes in market volatility, arbitrage opportunity also depends on the number of people chasing it. Indians tend to run after historical returns and the ballooning of arbitrage fund AUMs a few years ago was because of good historical returns generated by these funds. With too many people chasing the small pie, the opportunity reduced and the reverse cycle started. With historical returns coming down, its size also fell. The total AUM is now very low compared to what it was during its heyday in 2007-08. This is good for the current investors. However, keep a close watch and move out if the opportunity is drying up.

… while the sun shines

Arbitrage schemes of mutual funds have fetched better returns than equity and debt schemes in the past one year, thanks to smaller asset sizes and algorithmic trading. These funds have given post-tax returns of 9% over the year, compared with 8.4% for debt funds. Value of equity funds fell 4.1%, according to a CRISIL study. All said and done, arbitrage fund as a category has shrunk in size. Net investment in this category is minuscule. Over the past one year, equity markets have been volatile, thereby creating opportunities for such funds with lower assets under management to generate superior returns. Arbitrage funds have a low risk-return trade-off and generate moderate returns. During the volatile 2006-08 period, arbitrage funds gave healthy post-tax returns of 8-9%. Risk-averse investors, who shy away from equities owing to high volatility, can look at arbitrage funds as a relatively safer option within equities, according to the CRISIL study. According to CRISIL Research, arbitrage funds can act as an alternative to short-term debt funds as they have generated higher returns in the short-term. During the past three and six months, arbitrage funds gave post-tax returns of 2.38% and 4.28%, respectively, vis-a-vis 1.84% and 3.5% for debt short-term funds and 1.99% and 3.74% for ultra short-term funds.

 

No investment is totally risk free. Understand the risks involved before taking the plunge.