FUND FLAVOUR

March 2016

Arbitrage Funds – risk free, tax free!

Can you have your cake and eat it too? The obvious answer to this question is a resounding “No”! But there does exist an investment avenue which yields risk-free, tax-free return of around 8% p.a. to 9% p.a.!! Enter Arbitrage Funds.

If you wish to make your money work harder than what it does in a bank without taking additional risk and at the same time maintain immediate liquidity, arbitrage funds provide the best solution.  Debt funds are not the answer. They come with interest rate risk. Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Then there is the spectre of credit risk. Debt or Income Funds essentially invest in fixed income securities of corporates. Now, if the corporate were to default on repaying its obligations, the fund and consequently its investors will get into trouble. The recent Amtek Auto incident is a case in point.

Therefore, investors have to look elsewhere…..some place that gives them fixed return at no risk. Investors not familiar with Arbitrage Funds might just end up thinking that these are just equity oriented schemes with another fancy name. However, this is not so. What such funds aim to do is to take advantage of the arbitrage opportunities between the cash and the futures market to generate fixed income. Therefore, though classified as equity, these are a type of income scheme. The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market.

How does an Arbitrage Fund work?

You should first understand the word “arbitrage”. In short, arbitrage means – “simultaneous purchase and sale of an asset in order to profit from a difference in the price”.

Let me give you an example

·         Imagine that a person wants to buy a second hand phone and is ready to pay Rs 2,000 for it. You go to OLX and see that the same phone is selling at Rs 1,200 there. You then buy the phone at 1200 and sell it at 2000 and make the profit of Rs 800. This is one example of arbitrage

·         Another example of arbitrage is gold. Gold prices are different in various cities. So there is a possibility that gold can be cheaper in Bangalore compared to Chennai and a gold dealer buys it from Bangalore and sells it in Chennai.

In the examples above, the problem is that the buying and selling happens at two different times, and hence there is small risk.

But what will happen if you are able to buy and sell at the same time? In that case, there is no risk, because instantly you are locking the profits (the difference in price)

This is exactly what happens in Arbitrage mutual funds

In the case of arbitrage mutual funds, the funds explore the arbitrage opportunities where the same stock is quoting at two different prices at BSE and NSE at the same time and they buy and sell in different markets and make the profits. The other thing which an arbitrage fund does is use cash and derivative markets. For example, a stock might be available at Rs 100 on stock market, but it might be selling at Rs 104 in future’s market and they make the difference as profits.

Arbitrage funds take controlled exposure to equities. What do we mean by controlled exposure? They will simply carry out strategies which would have offsetting positions on various markets at the same time. In other words, the schemes take hedged positions that make them ‘market neutral’ or with no specific equity risk.

Features of Arbitrage Funds

• Arbitrage funds are the best alternative to short-term debt funds as they generate higher returns in the short-term.
• Most of the Arbitrage funds have equity ratio over 65% and are classified as equity funds. Hence, the long-term returns are tax free.
• The short-term capital gains are taxed at a special rate of 15% (plus surcharge)
• If you opt for dividend option of Arbitrage funds, the dividends are tax-free for equity funds.
• While choosing arbitrage funds, you also need to look at the exit loads that range from 0.25% to 1% for exits varying from seven days to one year.
• Most of the arbitrage funds have a small exit load anywhere from 0.25% to 0.5% if you take out the money before 90 days. In the case of liquid funds, there does not exist any exit load and you can take out the money even in a week without any loads. 
• When markets are in stabilized mode, then there would be no scope for volatility and hence there will be no opportunity for earnings.
• Coming to returns, Arbitrage funds can be compared to a Liquid fund and a good Arbitrage fund's returns potentials is in range of 8% - 9% depending on the time frame and the yield of the instruments they have invested into.
• In the case of an arbitrage fund, redemption can take 3-4 days. Whereas, in the case of Liquid funds, this is just 1 day.
• These funds are not suitable for long term wealth creation. They are mainly used for parking surplus money for short term duration in a tax efficient way compared to fixed deposits. It is recommended to have tactical investment in arbitrage funds from short term debt schemes for a period between 1 to 3 years.

Performance of Arbitrage Funds

The risk free nature of the returns is the USP of the product. There are around 14 Arbitrage Funds that are operating currently with the one year return being in the range of 7% p.a. to 8.60% p.a. The five year return is around 8.5% p.a. All the funds are yielding positive on YTD basis. The performance of these funds has also never faltered on other timelines as well with Reliance Arbitrage being the consistent performer with returns of above 8%. In the one year ended August 8, 2015 the best performing fund in the category was Kotak Equity Arbitrage Fund, with returns of 10.03%. The worst performing was Birla Sun Life Enhanced Arbitrage Fund, which returned 8.10%.

On the AUM front, Arbitrage funds basket has more than doubled from Rs 12000 crores of AUM in Jan 15, 2015 to around 30000 crores in Nov 15, 2015. JM Funds lead the pack with a corpus of Rs 5675 crores.

Arbitrage funds have been present in the market for a long time. But their returns have been comparable with those given by short-term debt funds, which is why they have not got much investor interest. These funds got a lot of attention as a substitute for short-term debt funds after the Union Budget 2015 reduced the tax benefits for investors in debt funds. This then becomes another alternative apart from Fixed Maturity Plans & Floating Rate schemes to beat the risks inherent in income schemes. Those who want a breather from the equity market and those who look for safe fixed income, should invest in Arbitrage Funds.

Volatile or unidirectional?

Do arbitrage funds do well only in volatile markets? The answer seems yes, because in volatile markets, there is a wide gap in prices in cash and derivatives segments, providing opportunities for making money. If you analyse data since 2007 and split it in periods when either the Nifty has moved significantly upwards or significantly downwards, you will observe that the base case returns delivered by arbitrage funds have been 7-8%. The highest returns have been 10-11%, proving that these funds can deliver stable and consistent returns across market cycles. Irrespective of the market movement, there will be a difference in cash and futures markets. This will ensure that arbitrage opportunities exist even if the markets are unidirectional or range-bound.

Lately, this fund is getting more funds and AMCs have managed to increase their AUMs mainly due to tax benefits over debt funds. Now, the question is whether the charm of arbitrage funds is here to sustain for a longer duration? Keeping this perspective in mind, we should understand that arbitrage funds have been around for more than five years in the market. After 2008, stock market correction, volumes in the fund had dried down, arbitrage funds had also lost their sheen. Currently, the taxation advantage in the short term over debt funds is what makes these funds attractive among investors. This short-term incentive is also an arbitrage opportunity, which should correct itself in due course, like any other mispricing opportunities.

In a nutshell, investors need to understand the concept of derivatives before investing in any arbitrage fund. It should not be treated as an equity fund aiming for capital appreciation. The returns of these funds are directly proportional to the volatility in equity markets: the more, the merrier. Exposure to these funds should not be more than 5% to 10% of the overall portfolio. They can be a good investment candidate for short term or as a “parking fund” for long term equity investments as they offer a tax advantage over debt funds.