FUND FLAVOUR

March 2015

How about earning high returns from the stock market without bearing any risk? Surprised, aren’t you? Yes, it is true. There is something called as arbitrage that lets you eliminate risk from stock market investing. Fund houses have latched on to this strategy and introduced arbitrage funds. They have marketed these funds as “risk-free”. But are they really risk-free? Is there no likelihood of suffering a loss by investing in these funds?

The icing on the cake

Arbitrage mutual funds are taxed like equity mutual funds. Gains realised by holding units for more than a year are tax free.  Typically returns of arbitrage funds are similar to those of liquid funds and ultra-short term funds, that is, about 6-8%. Arbitrage opportunities abound in turbulent markets and they have done quite well in recent times. Returns should not be a factor for choosing them though. The tax-free and risk-free nature of such funds can be exploited in many ways:

• They are ideal candidates for short-term goals where capital protection and minimum tax-outgo are more important than returns. Since losses can arise under unusual circumstances it is best to use it for non-crucial short-term goals.
• They are decent candidates for parking a portion of your emergency fund. A SB account and liquid funds are ideal candidates in terms of liquidity. A small portion can be kept in arbitrage funds so that we can let it grow without worrying about tax. Note: Redemption can take about 10 days or so.
• When we have a home loan going it is best to set aside about 3 months EMI as part of the emergency fund. This part alone can be put in an arbitrage fund since liquidity is typically not crucial.

The concept of arbitrage funds looks good but with high computing power and well developed algorithms, the arbitrage opportunities are limited, thereby, limiting their returns. These funds work well in volatile market conditions but when the markets are going in one direction, the performance suffers.

The modus operandi

The first qualification to invest in these funds is that you understand how they work. Why is this so important? For two reasons: one, if you are looking for substitutes for debt funds these really are not debt funds although their risk profile may mimic low-risk debt. Two, if you understood these funds as being equity funds, then you may wonder why they deliver low returns, when equity funds manage higher returns. Hence, it is important to understand that arbitrage funds primarily use hedging strategies. In the process, if they generate some profit as a result of mis-pricing, you benefit more. Else, you benefit about the same as you would with liquid or ultra-short-term funds.

People who are not familiar with the term arbitrage might think it as another equity fund. This is not true. The main aim of this fund is to seek an arbitrage opportunity between the cash and the derivative markets and to generate an income. A major part of the fund’s portfolio is invested into equities and rest is used for arbitrage opportunities. There is always an arbitrage opportunity available in the stock market. What is needed is the knack to catch the opportunity. Suppose ABC stock is trading in the cash market at Rs. 1,000 and the future price of the same stock is Rs. 1,010. Now, the fund manager can see the arbitrage opportunity and will sell the future contract in the derivative market and at the same time buy an equivalent number of shares in the cash market. He will hold this position till the expiry. Now as it is definite that the cash price and future price will be the same on the expiry date, he will reverse the transactions. He will sell the shares in the cash market and will buy the future contract, thus making a definitive profit. Irrespective of the price, the fund manager will make a profit. It sounds very easy and simple but the problem lies in finding such opportunities very frequently.

Recent euphoria… Arbitrage funds, first introduced in the Indian markets about a decade ago in 2004, managed limited assets in the initial years. After almost drying up in 2008, they again started attracting modest assets till June 2014. As on June 30, 2014, arbitrage funds had assets under management worth Rs. 5567 crores. Interestingly, just two funds - IDFC Arbitrage Fund - Regular Plan and Kotak Equity Arbitrage Fund account for more than half of these assets. Since June 2014, three asset management companies have launched arbitrage funds, taking the number of such funds in the Indian market to 14. Assets of arbitrage funds rose from around Rs. 6000 crores in June 2014 to more than Rs 14000 crores in August 2014. These funds have got a lot of attention as a substitute for short-term debt funds after the Union Budget 2014 reduced the tax benefits for investors in debt funds. Returns on investments up to 12 months are taxed at 15% and there is zero tax on investments held for more than a year. The government, in the Budget, increased long-term capital gains tax for all schemes, other than equity-oriented schemes, to 20% from 10%. In addition, the period defined as long-term was increased from 12 months to 36 months.

…and short-term disappointment?

Investors, who deployed money in arbitrage schemes soon after the government raised taxes on debt funds in July 2014, are a disappointed lot. Many of them are switching back to debt funds, due to a positive interest rate scenario. In the last six months, the arbitrage fund category underperformed fixed income schemes even as the stock markets rallied to new highs. Arbitrage schemes, which aim to benefit from price anomalies between shares and futures contracts, fetch returns similar to fixed income instruments. In the last six months, arbitrage funds have returned 3.93%, ultra-short term funds have given a return of 4.4%, and income funds gave a return of 8.66%, according to data from Value Research. But, does this make arbitrage funds a bad choice? Well, not quite. The change in tax rules for non-equity funds in Budget 2014 saw investors migrating from debt funds to arbitrage funds and, therefore, collections zoomed during July and August 2014 to see the assets under management (AUM) for arbitrage funds almost double. Since more money was chasing the limited arbitrage opportunity in the market, these funds witnessed a fall in returns. There are other reasons for the fall in returns of arbitrage funds. There has been an overall decline in the arbitrage opportunity in the market with the India Vix (Volatility Index) hitting an all-time low in August 2014. Trading activities shifting from large-cap companies, which are part of the F&O segment, to mid-cap companies outside the F&O segment, is yet another reason for the fall in arbitrage opportunity. This explains why the total value of stock futures is not moving up with the market indices in the last few months. The stock market getting into a correction mode is another reason for the fall in the arbitrage opportunity. The arbitrage spread will be more when the market is bullish and the spread declines when the market cools off. The fall in volatility is temporary and the returns from arbitrage funds should improve when volatility spikes once again. Returns from arbitrage funds will never have a steady pattern like that of liquid funds. There will be some months of low returns and some months of high returns. This is also not the first time that the returns of arbitrage funds have come down to these levels. The category average return had fallen to 6.28% in November 2013. The arbitrage opportunity has now started picking up and is expected to generate better returns for the category.

Safe bet in the six-month time frame

Arbitrage funds buy stocks in the cash market and sell an equivalent amount of futures. The returns would, however, vary based on the premiums at which the futures trade compared to the cash price. Therefore, these funds are safe with a minimum time horizon of six months. Moreover, since arbitrage opportunities are limited, we have seen returns from these funds trend low after the combined AUMs of arbitrage funds cross a certain threshold. Besides understanding the thesis behind these funds, if you are looking at a time frame of at least six months and are primarily looking for tax efficient ways to invest in low-risk options, arbitrage funds can work for you. Investors should invest in accordance with their risk tolerance, return expectation, and goals targeted. If investors or advisors can figure out some opportunities like expectation of fall in interest rates, then it is possible that you make good money from the same in short term. But when things are uncertain in stock market and even in debt market then arbitrage funds can be a good bet.

Points to ponder

• Redeem your funds on the last Thursday of the month – there is no restriction on when you can withdraw your funds but as the derivatives settlement happen on the last Thursday of the month, it is good to redeem on that day.
• Consider exit loads – Some funds have exit loads in the range of 0.25% to 1% if the exit is between 30 days to 6 months. Keep in mind your investment time frame while choosing the fund.
• Taxation – the real tax benefit on arbitrage fund is realized when you are invested for more than a year. So plan accordingly.
• Not for long very long term – these funds are meant for parking short term money, i.e. mainly for 1 -3 years’ time frame. For longer duration you should either look for equity funds or debt funds.
• Go direct– The expense ratio difference between Direct and regular funds vary between 0.3% and 0.5%. So choosing “Direct” option would increase your return by 0.5%
• No assured return – the returns from arbitrage funds are close to that of fixed deposits but there is no assurance of the same. It may vary widely at times.
• Some risk is involved – there have been cases where arbitrage funds have given minor negative returns in a quarter. So these funds are not suited for parking very short term money.