Monday, March 25, 2019

March 2019

Overall assets under management (AUM) of the mutual fund industry stood at Rs 23.16 lakh crore at the end of February 2019, almost flat compared to the previous month according to the data released by the Association of Mutual Funds in India (AMFI). The industry witnessed a total outflow of Rs 20,083 crore in February 2019 compared to an inflow of Rs 65,439 crore in January 2019 on the back of a moderation in flows into equity funds and redemptions in liquid funds. Inflows into equity funds declined 17% on a month-on-month (MoM) basis to Rs 5,122 crore in February 2019. The decline can be attributed to fading equity outlook, market volatility and weak global cues. While the overall equity flows have been weakening, investment in equity funds through systematic investment plans (SIPs), which is relatively sticky, continued to hold its sway with Rs 8,095 crore of SIP funds mobilised in February 2019. The high share of SIP contribution has been the key success story of the mutual fund industry in the past couple of years. Systematic investment plans (SIPs) have been the saving grace for the mutual fund industry amid market volatility. According to the data provided by AMFI, the 43-member-strong mutual fund industry has managed to garner Rs 8095 crore through SIPs in February 2019, slightly higher than the Rs 8,064 crore collected in January 2019. Over the last five months, AMFI and players from the industry have launched campaigns such as 'mutual funds sahi hai' and Jan Nivesh, which is helping garner interest for a push product like mutual funds. Generally, SIPs are the preferred route for retail investors to deploy money in mutual funds as it helps them reduce market timing risk.

Fund flows into mutual funds reversed in February 2019, with outflows at Rs 20,083 crore, after the 43-player industry witnessed net inflows of Rs 65,439 crore in January 2019, according to data from AMFI. Cash plans, or liquid schemes, reported the highest outflows across all mutual fund categories. This category registered outflows of over Rs 24,509 crore in February 2019 as against an inflow of Rs 58,637 crore in January 2019. Companies normally park their money in liquid schemes to meet their short-term needs instead of keeping their money idle in a non-interest bearing current account. Since liquid plans do not levy any entry or exit fee, they facilitate easy cash management. Income funds too saw outflows of Rs 4,214 crore in February 2019. Debt fund investors are still shying away from making investments after the recent crisis at IL&FS affected these schemes. The trouble, which began after multiple defaults by Infrastructure Leasing & Financial Services (IL&FS) came to light a few months back, impacted debt funds that held securities issued by it, worth Rs 2,800 crore. For the second consecutive month, balanced funds saw net outflows of Rs 1,077 crore in February 2019, after outflows of Rs 952 crore in January 2019. Equity funds continued their downward journey for the fourth straight month, with the quantum of inflows declining 16.9% month-on-month to Rs 5,122 crore in February 2019.
Equity mutual funds account for 5.9% of India’s stock market capitalisation as on February 2019. It has grown by 0.6% in the last one year, shows a recent Motilal Oswal Report titled ‘Fund Folio – Indian Mutual Fund Tracker’.  India’s equity market capitalisation stood at Rs. 140 lakh crore while the mutual fund industry’s equity AUM was at Rs.8.29 lakh crore at the end of February 2019. Equity AUM includes pure equity, ELSS and arbitrage funds. Strong retail participation in equity markets has helped the growth in equity AUM. The industry saw net inflows of Rs. 1 lakh crore in equity funds in April-February 2018-19. According to the report, while the street exercised caution amid a flurry of unsupportive domestic and global cues, mutual fund investors appeared to be undeterred by market volatility as reflected by the record SIP flows. Monthly inflow in SIPs was at an all-time high of 8,095 crore in February 2019, growing by 26% year-on-year or 2 times in last two years, shared the report. The healthy mutual fund inflows in equity markets act as a counterbalancing force against selling pressures. Overall, mutual fund equity AUM grew by 7% in the last one year (from Rs. 7.76 lakh crore in February 2018 to Rs. 8.29 lakh crore in February 2019).    

Piquant Parade

Reliance Nippon Life AMC may soon see a change of ownership. Reliance Capital, which owns 42.88% stake in the fund house, has invited Nippon Life its joint venture (JV) partner to acquire its stake in the business. Currently both partners hold equal ownership in the JV. Reliance Capital expects to sell it shares to Nippon Life at a premium. The business group is reportedly planning to divest its share in various businesses as it is under pressure from lenders to pay off its huge outstanding debt. Reliance Nippon Life AMC is the fifth largest fund house by AUM having assets of Rs. 2.43 lakh crore in January 2019. If Nippon acquires Reliance Capital’s stake, it will become the largest foreign owned fund house in India. 

According to SEBI’s website, two new players Geojit Financial Services and SREI Infrastructure Finance have applied to launch their mutual fund business. Altogether, six players including Frontline Capital Services, Equity Intelligence India, Samco Securities and Karvy Stock Broking are awaiting approval from SEBI to launch their mutual fund business in India. While Geojit Financial Securities is in financial distribution business, SREI Infrastructure is already into Infrastructure Debt Fund (IDF) business and has AIF, insurance broking and infrastructure financing business. Geojit Financial Services approached SEBI in August 2018. Similarly, SREI Infrastructure Finance has applied for AMC license in February 2019. Last year, Trust Investment Advisors and Muthoot Finance got SEBI in-principle approval to float asset management business. SEBI rules say that the sponsor applying for a mutual fund licence must be in the financial services business for five years and needs to have a positive net worth for five years. The sponsor should have earned profits in three of the previous five years, including the latest year. SEBI conducts an on-site due diligence of sponsors before granting approval.

Regulatory Rigmarole

SEBI has said that mutual funds will have to disclose assets under management of their schemes on a daily basis, coupled with an additional benchmark and product labelling. In a clarification letter to AMFI on March 7, 2019 the market regulator said, “The AUM of all schemes except liquid schemes has to be disclosed on a daily basis on the AMFI website.” AMFI had earlier requested SEBI to do away with the requirement of publishing the daily AUM of mutual schemes. SEBI said that in case of liquid schemes the closing AUM, and the AUM of the previous month has to be disclosed on the AMFI website on a daily basis. However, if the AUM movement of the schemes is over 10% from the previously disclosed AUM, fund houses will have to disclose the AUM of that day. AMFI had asked to do away with the requirement to prevent unhealthy competition. Fund managers said that the disclosure of AUM on a daily basis may lead to unhealthy competition among fund houses for the shoring up of assets. Also, the extensive media glare on AUM figures may result in unnecessary pressure on funds. At the same time, SEBI accepted AMFI’s request on the performance disclosure of short term schemes such as overnight fund, liquid fund, ultra-short duration fund, low duration fund, and money market funds. SEBI said that mutual fund houses will have to disclose the performance for a period of seven days, 15 days, one month, three months and six months. SEBI also clarified that AMCs can disclose AUM of growth option of both regular and direct plans. In the same letter, SEBI said it has modified the formula of calculating the total expense ratio (TER) for beyond 30 (B30) cities. TER is a percentage of a scheme's corpus that a mutual fund house charges towards expenses which include administrative and management expenses. Earlier, only 'retail' assets were included in calculating the ratio. With the new formula, SEBI has allowed fund houses to consider both, retail and HNI assets while calculating the ratio. The ratio at present is 30 bps of the total assets garnered.

SEBI has clarified that AMCs can no longer use AMC account to compensate their distributors even if they have made a commitment. AMCs can no longer pay upfront commission even on assets that you have brought before October 22, 2018. In a recent clarification, SEBI has asked fund houses not to honour their commercial commitment that they have made to distributors before the implementation of ban on upfront commission.

AMFI has sought clarification from the government on stamp duty tax to be levied on financial products including mutual funds. Earlier, in interim budget 2019, the Union Finance Ministry has announced that the government would levy stamp duty on financial securities transactions, which includes financial instruments like direct stocks and mutual funds. “Currently, TER does not include stamp duty tax. Hence, we have requested finance ministry and SEBI to make necessary changes to the TER structure. Ideally, investors should bear stamp duty tax on mutual funds.” Since mutual funds deal with shares, every time a fund manager executes transaction, the fund has to pay stamp duty along with securities transaction tax. “Currently, the mutual fund industry executes transaction of Rs.5 lakh crore each month in equity and debt markets. Hence, the impact of stamp duty would be large. Also, the impact would be more on funds with high turnover ratio,” he said. He further said that while government is yet to announce the rate at which stamp duty will be levied on demat transactions, it is understood that it would be 0.005%. This would be implemented from April 1, 2019, he said. Earlier, the government had waived off stamp duty in transaction of securities in demat form. However, the government has proposed to re-introduce this duty. Also, stock exchanges will have to track origin of investors to distribute stamp duty among states.

After the introduction of side-pocketing in mutual funds, SEBI has now tightened norms for liquid funds following a series of credit episodes. SEBI has decided to introduce mark-to-market valuation for debt securities having maturity of 30 days and more. Simply put, liquid funds may become more volatile going forward. SEBI said, “The residual maturity limit for amortization based valuation by mutual funds shall be reduced from existing 60 days to 30 days.” Currently, SEBI rules say that fund houses have to do mark-to-market valuations of securities having maturity of 60 days and more. Debt market experts believe that fund managers will reduce average maturity on their portfolio to less than 30 days to avoid doing mark-to-market valuation. Hence, they would sell debt instruments having maturity between 31 days and 60 days. Liquid funds have been holding debt instruments with less than 60 day residual maturity so that they do not have to mark-to-market it which helps in reducing volatility in liquid funds. As per the new rule, the market to market (amortisation) limit has been reduced to 30 days which means liquid funds will have to do mark-to-market for debt having residual maturity between 31 and 60 days. To avoid this, liquid funds will want to move to papers with residual maturity of less than 30 days. This will lead to increase in yield for papers with residual maturity between 31 and 60 days and fund turnover will increase. With stamp duty coming into picture, we can expect a marginal decrease in liquid fund returns. SEBI further said that the difference between traded price and price quoted by rating agencies of a security should not exceed 0.025%. This was reduced from 0.1%. SEBI has asked AMFI to appoint valuation agencies to provide valuation of money market and debt securities rated below investment grade. Currently, most fund houses rely on ratings by agencies to derive NAV. However, AMCs can deviate from valuation provided by agencies by giving rationale for such deviations.

SEBI has asked fund houses to fund investor awareness programs (IAPs) from their scheme accounts. As per SEBI norms, mutual funds/ AMCs should annually set apart at least 2 bps on daily net assets within the maximum limit of TER for investor education and awareness initiatives. However, AMFI asked SEBI if fund houses could fund IAPs from AMC books. AMFI asked, “It may be clarified that expenditure in connection with investor education may be borne by both AMC and schemes, i.e., the expenditure towards investor education and awareness initiative need not mandatorily be charged to the schemes.” However, SEBI in its response to AMFI clarified that fund houses can fund IAPs from AMC books only if such expenses exceed 2bps from schemes. SEBI said, “The request of AMFI in this regard is not acceded to. Any expenses towards investor education and awareness initiatives in excess of the amount set apart through 2 bps shall be borne by the AMC.” AMFI data shows that 35 AMCs have conducted 8,203 programmes in 211 cities covering over 4.03 lakh participants across the country in FY 2016-17. So far, 40 AMCs have conducted 72,257 programmes in 485 cities, covering over 25 lakh participants between May 2010 and May 2017.

SEBI has allowed fund houses to charge up to 2bps of the scheme AUM or actual cost whichever is lower from AMC book for operational expenses such as registration of SIPs, payment gateway charges, transaction platform charges, annual custody fees, call centre fees, RTA NFO charges, CKYC charges, KRA charges and so on. However, SEBI has clarified that these charges have to be small in value and high in volume. In fact, SEBI has asked AMFI to make a list of these expenses in consultation with the market regulator through best practices circular. AMFI is expected to submit its recommendation soon. Further, SEBI has cautioned that if they found AMCs misusing this facility, they will take necessary action against such AMCs. SEBI said, “Misuse of the carve-out, if any, shall be viewed very seriously and necessary action against AMCs including withdrawal of the said carve-out facility may also be considered.”

At times, fund houses have to borrow money at higher rates i.e. interest rates higher than YTM of the portfolio to meet redemption pressure. SEBI has allowed fund houses to use AMC’s book if the borrowing cost exceeds running yield or yield to maturity (YTM) of the scheme portfolio. In a letter sent to AMFI, the market regulator has clarified that the cost of borrowings by a mutual fund scheme would be adjusted against the portfolio yield and if the cost of borrowings exceeds such a yield, then fund houses can use the AMC book to repay additional interest on such borrowing. Simply put, if a scheme carries yield to maturity of 8% and borrows money at 8.5% to meet its redemption pressure, the fund house managing such a scheme has to pay additional interest of 0.5% from the AMC book ensuring that the scheme expenses remain intact. Earlier, AMFI had requested SEBI that the cost of borrowing made to manage redemptions in respect of liquid funds to the extent of YTM or running yield of the fund as on the previous day should be charged to the scheme and any excess cost over YTM or running yield of the previous day should be borne by the AMC. SEBI norms allow fund houses to borrow up to 20% of the total AUM to meet redemption pressure.

To strengthen its ‘Go Green’ initiative, SEBI has asked fund houses to submit links of their advertisements by sending an email to comply with advertisement norms within 7 days from the date of issue of advertisements. So far, fund houses have filed hard copies of their advertisement to comply with SEBI Mutual Fund regulations. In a circular, SEBI said, “In continuation to the various Go Green initiatives in Mutual Funds, the Mutual Funds are now advised to submit links to access the advertisements to be filed under the MF Regulations by sending the same through e-mail to SEBI at However, advertisement materials like pamphlets may be submitted as attachment along with e-mail, if the size of the attachment does not exceed 250 KB.” In addition, the compliance head of fund houses will have to ensure that these advertisements are in line with the advertisement code. SEBI said, “While sending the e-mail, the compliance officer of respective Mutual Fund shall expressly confirm that the advertisement is in compliance with the Advertisement code specified in the sixth schedule of the MF regulations.” The circular has come into effect immediately.

In a circular, the ministry of finance has clarified that taxpayers cannot avail benefits of composition scheme under GST norms if they provide services in other states. Simply put, the composition scheme does not allow distributors to avail benefits if they provide interstate services. For instance, if a Chennai based distributor is selling the schemes of a Mumbai based fund house, he cannot avail the benefits of composition scheme. Since practically all distributors work with AMCs that are based out of Maharashtra and Tamil Nadu, they cannot avail the benefits. That means only a fraction of Maharashtra distributors who do not have business with AMCs out of Maharashtra and earn between Rs.20 lakh and Rs.50 lakh can avail the benefits of composition scheme. Earlier, the Union Finance Minister Arun Jaitley had announced the introduction of composition schemes for services sector. Under the scheme, service providers earning up to Rs.50 lakh could pay GST rate of 6% instead of 18% with effect from April 1, 2019. However, these service providers cannot avail input credits if they opt for the composition scheme. Also, they will have to pay taxes quarterly but file returns annually.

Ultra HNI population in India is expected to grow at 39% to reach 2697 by 2023, says the Knight Frank Wealth report. India is witnessing a rapid growth in personal wealth, states the report with the country’s ultra HNI population growing by 24% in the last five years ending 2018. Unsurprisingly, Mumbai and New Delhi are two prominent cities in terms of Ultra HNI population in India. With 797 such individuals residing in Mumbai in 2018, the city is home to 41% of the country’s UHNWI population. New Delhi meanwhile is home to 211 UHNWIs or 11% of the country’s wealthy population. While Mumbai leads the country in terms of personal wealth, Bengaluru will lead the country in terms of wealth creation over the next five years. The city’s GDP is expected to grow by almost 60% in the next five years. Consequently, there will be 40% increase in the cities ultra HNI population in five years, shares the report.

Monday, March 18, 2019

March 2019

NFOs of various hues adorn the March 2019 NFONEST.

After the default of IL&FS hit liquid schemes, mutual fund houses are turning towards overnight funds that prove to be less risky. Over the last six months, since the IL&FS crisis surfaced, 16 fund houses have sought the Securities and Exchange Board of India’s approval to launch overnight funds. These fund houses include — Yes Mutual Fund, Edelweiss Mutual Fund, HSBC Mutual Fund, Tata Mutual Fund, DHFL Mutual Fund, Mahindra Mutual Fund, BNP Paribas Mutual Fund, Axis Mutual Fund, ICICI Prudential Mutual Fund, DSP Mutual Fund, Reliance Mutual Fund, and IDFC Mutual Fund, among others. ICICI Prudential Mutual Fund and Aditya Birla Sun Life Mutual Fund have already launched their overnight funds. Overnight funds invest their assets in CBLO (collateralised borrowing and lending obligations) and repo/reverse repo instruments that mature in one day, while liquid funds invest in treasury bills, commercial paper and certificate of deposit that have a maturity up to 91 days. Overnight funds expose investors neither to credit risk nor duration risk but yield paltry returns of about 6.4%. Liquid funds do slightly better.

Sundaram Overnight Fund
Opens: March 15, 2019
Closes: March 20, 2019

Sundaram Overnight Fund is an open-ended debt scheme which proposes to invest in the overnight securities, the securities having maturity period of one business day. The objective of this scheme is to generate an income by investing in debt, money market instruments, cash and cash related instruments having overnight maturity. As a benchmark, this fund will follow the Nifty 1D Rate Index. It has a low risk associated with it. The scheme may invest in repo/reverse repo transactions in corporate debt securities. It may also invest in liquid schemes of mutual funds. Sundaram Overnight Fund will be jointly managed by Mr. Siddharth Chaudhary and Mr. Sandeep Agarwal.

SBI Capital Protection Oriented Fund – Series A (Plan 2)
Opens: March 11, 2019
Closes: March 25, 2019

SBI Mutual Fund has launched a new closed ended growth scheme named SBI Capital Protection Oriented Fund - Series A (Plan 2) with maturity period of 1265 days from the launch date. The scheme endeavors to protect the capital by investing in high quality fixed income securities that are maturing on or before the maturity of the scheme as the primary objective and generate capital appreciation by investing in equity and equity related instruments as a secondary objective. Mr. Rajeev Radhakrishnan shall manage the debt portion and Mr. Ruchit Mehta the equity portion. The performance of the scheme will be benchmarked against CRISIL Hybrid 85+15 - Conservative Index.

HSBC Large and Midcap Equity Fund
Opens: March 11, 2019
Closes: March 25, 2019

HSBC Large & Mid Cap Equity Fund is an open-ended scheme which will invest in both large and mid-cap stocks. It seeks to generate long-term growth of the invested capital.  HSBC Large and Mid-Cap Equity Fund proposes to allocate the assets into equity and equity-related securities where it will invest a minimum of 80% to a maximum of 100% of the total assets. It further proposes to invest a minimum of 35% to a maximum of 65% of the total assets in the stocks of large and mid-cap companies, where a medium to high risk is associated. It will invest in the range of 0-30% in the stocks of other than large and mid-cap companies. It proposes to invest from 0 to 20% of the total assets in debt and money market instruments also which will include the cash and cash equivalents. A low to medium risk is associated with this approach. The scheme will follow the Nifty Large & Mid-Cap 250 TRI as benchmark index. Mr Neelotpal Sahai will be the fund manager.

ICICI Prudential Quant Fund, Mirae Asset Focused Fund, Sundaram Ultra Short-term Fund, Edelweiss Overnight Fund, Yes Overnight Fund, Shriram Balanced Advantage Fund, Shriram Large Cap Fund and CPSE ETF FFO 4 are expected to be launched in the coming months.

Monday, March 11, 2019

March 2019

All the GEMs from the 2018 GEMGAZE have performed reasonably well through thick and thin and figure prominently in the 2019 GEMGAZE too. 

Kotak Equity Arbitrage Fund Gem

Incorporated in September 2005, Kotak Equity Arbitrage Fund has an AUM of Rs 12,537 crore. The fund is a blend of value and growth style of investing with an objective to generate income through arbitrage opportunities emerging out of pricing anomaly between the spot and futures market, and also through the deployment of surplus cash in fixed income instruments. 60% of the fund’s corpus is deployed in arbitrage trades and the rest is invested in FD, debt funds and securities. The fund has given annualized return of 7.44% since inception. The one-year return of the fund is 6.04% (6.55% for the direct plan) modestly ahead of the category average of 5.38%. The top three sectors are finance, chemicals and technology. Top five holdings constitute 30.95% of the portfolio. The portfolio turnover ratio is 382% and the expense ratio is 0.96% (0.49% for the direct plan). The fund is benchmarked against the Nifty Fifty Arbitrage Total Return Index with Mr. Deepak Gupta efficiently managing the fund since September 2008.

JM Arbitrage Fund (erstwhile JM Arbitrage Advantage Fund)  Gem

The Rs 854 crore JM Arbitrage Fund, incorporated in July 2006, has earned a one-year return of 5.23% (5.65% for the direct plan) trailing the category average return of 5.28% (6.01% for the direct plan). Top five holdings constitute 39.6% of the portfolio with finance, energy and engineering forming the top three sectors. Instruments in arbitrage trades constitute 70.1% of the portfolio with 29.9% in debt. The fund is benchmarked against the NIFTY 50 Arbitrage Index. The fund is managed by Chaitanya Choksi since February 2011 and Asit Bhandarkar and Sanjay Kumar Chhabaria since July 2014.

SBI Arbitrage Opportunities Fund Gem

SBI Arbitrage Opportunities Fund, incorporated in November 2006, has an AUM of Rs 2,866 crore. Its one-year return is 5.80% (6.48% for direct plan), as against the category average return of 5.38% (6.01% for direct plan). The top five holdings constitute 19.5% of the portfolio. Finance, energy and healthcare are the top three sectors. 70.19% of the portfolio is made up of instruments in arbitrage trade with 29.81% in debt. The portfolio turnover ratio of the fund is a massive 1071%. The expense ratio is comparatively low at 0.75% (0.23% for direct plan). The fund is benchmarked against the NIFTY 50 Arbitrage Index. The fund is managed by Neeraj Kumar since October 2012.

IDFC Arbitrage Fund Gem

IDFC Arbitrage Fund is a twelve-year old fund with an AUM of Rs 3,244 crore. The objective of the fund is to generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and the derivative segments of the equity markets and the arbitrage opportunities available within the derivative segment and by investing the balance in debt and money market instruments. The fund’s total exposure to arbitrage position is 71% of the portfolio and 29% is in debt and money market securities. The fund was launched in December 2006, and has given 7.12% since its launch. Its one-year return of 6.03% (6.8% for direct plan) is a tad higher than its category average of 5.38% (6.01% for direct plan) at present.  Top five holdings constitute 27.93% of the portfolio, with energy, healthcare and technology being the top three sectors. While the portfolio turnover ratio is high at 430%, the expense ratio is very low at 0.88% (0.35% for direct plan), an icing on the cake, indeed. The fund has been managed by Yogik Pitti since June 2013, Harshal Joshi since October 2016, and Arpit Kapoor since March 2017.

ICICI Prudential Equity Arbitrage Fund Gem

Incorporated in December 2006, ICICI Prudential Equity Arbitrage Fund has an AUM of Rs 8,354 crore. The fund’s objective is to generate low volatility returns by using arbitrage and other derivative strategies in equity markets and investments in a short-term debt portfolio. The fund manager employs cash arbitrage strategy in which it pockets the difference in price of stocks between the cash market and futures market. In index arbitrage strategy it takes equal and opposite positions in index futures and corresponding stock futures constituting the index in proportion to their respective weights in the index simultaneously, to lock in the price difference. The fund has performed consistently over a long period of time and has given annualized return of 7.55% since inception. The one-year return of the fund is 5.95% (6.59% for direct plans) slightly ahead of the category average of 5.38% (6.01% for direct plans). The top three sectors are finance, energy and healthcare. Top five holdings constitute 23.57% of the portfolio, with the equity exposure at 0.62% and debt constituting 24.17% of the portfolio with the rest in cash and cash equivalents. The portfolio turnover ratio is a towering 1040% and the expense ratio is 0.95% (0.35% for direct plan). The fund is benchmarked against the Nifty Fifty Arbitrage Fund Index with Mr. Manish Banthia, Mr. Kayzad Eghlim and Mr. Dharmesh Kakkad efficiently managing the fund since November 2009, February 2011 and September 2018 respectively.

Tuesday, March 05, 2019


March 2019

Low on risk, high on tax efficiency

Is there any investment option which can mimic the risk-return profile of a debt mutual fund and is also a tax efficient one like an equity oriented mutual fund? The answer is “yes”. An Arbitrage mutual fund is similar to say a liquid fund in terms of returns and is like an equity fund with respect to tax implications. It is generally a risk-free investment option. Arbitrage Funds work on the mispricing of equity shares in the spot and futures market. Essentially, it exploits the price differences between current and future securities to generate returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market. The difference in the cost price and selling price is the return you earn. This category of funds does not take a naked exposure to any individual company or an index as each buy transaction in the cash market has a corresponding sell transaction in the futures market. They make money from low-risk buy-and sell opportunities available in the cash and futures market and their risk profile is similar to that of a debt fund. In fact, many arbitrage funds use Crisil Liquid Fund Index as their benchmark. Its investment strategy to generate a return with less risk and taxation benefits has attracted a large number of investors. Arbitrage Funds gains profit from the difference in price of a security in various markets.  Let us explore this fascinating fund in detail.

The Modus Operandi

Suppose the equity share of a company ABC trades in the cash market at Rs. 1220 and in the future market at Rs.1235. The fund manager buys ABC share from cash market at Rs 1220 and sorts a futures contract to sell the shares at Rs 1235. Towards the end of the month when the prices coincide, the fund manager will sell the shares in the futures market and generate a risk-free profit of Rs.15/- per share less transaction costs. Conversely, if the fund manager feels the price to fall in future, he enters into a long contract in the futures market. He will short-sell the shares in the cash market at Rs 1235. At the expiry date, he buys shares in the futures market at Rs. 1220 to cover up his position and earns a profit of Rs. 15. In yet another scenario, the fund manager may buy an equity share for Rs. 100 in National Stock Exchange (NSE) and sell the same at Rs 120 in the Bombay Stock Exchange (BSE) to make a risk-free return. Arbitrage funds leverage benefit of the difference in pricing of the stock between the cash market and the futures market. This is achieved by buying a specified number of stocks from the cash market while the same number of futures contracts is sold simultaneously on the derivatives market if the overall market sentiment is bullish. On the other hand, if the market sentiment is bearish i.e. in case a majority of investors believe that stock prices will drop, the arbitrage fund will price the future contracts at a lower price and sell an equivalent number of shares on the cash market at the current (higher) spot price.

The pros…

Arbitrage funds offer a number of benefits, including:


Low Risk

One of the chief benefits of arbitrage funds is they are low risk. Because each security is bought and sold simultaneously, there is virtually none of the risk involved with longer-term investments. In addition, arbitrage funds invest part of their capital into debt securities, which are typically considered highly stable. If there is a shortage of profitable arbitrage trades, the fund invests more heavily in debt. This makes this type of fund very appealing to investors with low risk tolerance.
Another big advantage to arbitrage funds is they are some of the only low-risk securities that actually flourish when the market is highly volatile. This is because volatility leads to uncertainty among investors. The differential between the cash and futures markets is exaggerated. A highly stable market means individual stock prices are not exhibiting much change. Without any discernible bullish or bearish trends to either continue or reverse, investors have no reason to believe stock prices one month in the future will be much different from the current prices.
Volatility and risk go hand in hand. You cannot have huge gains or huge losses without either. Arbitrage funds are a good choice for cautious investors who still want to reap the benefits of a volatile market without taking on too much risk.


Taxed As Equity Funds

Though arbitrage funds are technically balanced or considered hybrid funds because they invest in both debt and equity, they invest primarily in equities by definition. Therefore, they are taxed as equity funds since equity represents at least 65% of the portfolio, on average. If you hold your shares in an arbitrage fund for more than a year, then any gains you receive are taxed at the capital gains rate, which is much lower than the ordinary income tax rate.

…and the Cons


Unpredictable Payoff

One of the primary disadvantages of arbitrage funds is their mediocre reliability. As noted above, arbitrage funds are not very profitable during stable markets. If there are not enough profitable arbitrage trades available, the fund may essentially become a bond fund, albeit temporarily. This can drastically reduce the fund's profitability, so actively managed equity funds tend to outperform arbitrage funds over the long term.


High Expense Ratios

The high number of trades that successful arbitrage fund management requires means the expense ratios for these types of funds can be quite high. Arbitrage funds can be a highly lucrative investment, especially during periods of increased volatility. However, their reliability and substantial expenses indicate they should not be the only type of investment in your portfolio.


The key takeaways
  • Arbitrage funds can be a good choice for investors who want to reap the benefits of a volatile market without taking on too much risk.
  • Though they are relatively low risk, the payoff can be unpredictable.
  • Arbitrage funds are taxed like equity funds.
  • Investors need to keep an eye on expense ratios, which can be high.
Things to consider


a. Risk factor

As trades occur on the stock exchange, there is no counter-party risk involved in these funds. Even when the fund manager is buying and selling shares in cash and futures market, there is no risk exposure to equities as is the case with other diversified equity funds. Though the ride looks smooth, do not get too comfortable with these funds. As more people start trading into arbitrage funds, there will be not many arbitrage opportunities available. The spread between cash and future market prices will erode, leaving little for the arbitrage focused investors.

b. Return

Arbitrage Funds may be a good opportunity to make reasonable returns for those who can understand it and then make the most of it. The fund manager tries to generate an  alpha using price differentials in markets. Historically, arbitrage funds have been found to give returns in the range of 7%-8% over a period of 5-10 years. If you are looking to earn moderate returns via a portfolio which has a perfect blend of debt and equity in a volatile market, arbitrage funds may be your thing. However, you need to keep one thing in mind that there are no guaranteed returns in arbitrage funds.

c. Cost of investment

Cost becomes an important consideration while evaluating arbitrage funds. These funds charge an annual fee called expense ratio , a percentage of the fund’s overall assets. It includes fund manager’s fee and fund management charges. Due to frequent trading, arbitrage funds would incur huge transaction costs and has a high turnover ratio. Additionally, the fund may levy exit loads for a period of 30 to 60 days to discourage investors from exiting early. All these costs may lead to increase in the expense ratio of the fund. A high expense ratio puts a downward pressure on your take-home returns.

d. Investment horizon

Arbitrage funds may be suitable for investors having a short to medium term horizon of 3 to 5 years. As these funds charge exit loads, you may consider them only when you are ready to stay invested for a period of at least 3-6 months. Please understand that fund returns are highly dependent on the existence of high volatility. So, choosing a lump sum investment would make sense over Systematic Investment Plans (SIPs). In the absence of volatility, liquid funds may give better returns than arbitrage funds over the same investment horizon. Hence, you need to keep the overall market scenario in mind while choosing arbitrage funds.

e. Financial goals

If you have short to medium term financial goals, then arbitrage funds are your thing. Instead of a regular savings bank account, you may use these funds to park excess funds in order to create an emergency fund and earn higher returns on them.. In case you were already invested in riskier havens equity funds, then you may begin a systematic transfer plan (STP) from the equity funds to a less risky haven like arbitrage funds as you approach completion of the financial goal. This would reduce your portfolio’s overall risk profile but at the same time reduce the returns also. You cannot expect to earn double-digit returns in arbitrage funds.

f. Tax on gains

These funds are treated as equity funds for the purpose of taxation. If you stay invested in them for a period of up to 1 year, you make short-term capital gains (STCG) which are taxable. STCG are taxed at the rate of 15%. If you stay invested in them for a period of more than 1 year, the gains will be treated as long term capital gains(LTCG). LTCG in excess of Rs.1lac is taxed at the rate of 10% without the benefit of indexation. Instead of sticking to pure debt funds, these funds are suitable for conservative investors who are in higher tax brackets to earn tax-efficient returns.

Points to ponder

·         Arbitrage Funds can generate more and better returns when markets are volatile. The volatile markets can create arbitrage opportunities. But, do not invest in Arbitrage funds with an objective to get double digit returns. The returns at best can be in the range of 5 to 8%.
·         These funds can generate better returns if major portion of fund corpus is invested in mid or small cap stocks or derivatives as they can be very volatile.
·         If you opt for ‘Dividend’ option, then DDT (Dividend Distribution Tax) is not applicable on the dividend declared by the funds. The dividends received from Arbitrage Funds are tax-free.
·         Though these funds mimic debt funds like risk profile but they cannot be considered as pure alternatives to Debt mutual Funds. In a declining interest rate scenario, Gilt Funds or Short-Term Debt Funds or even Dynamic Bond Funds can outperform Arbitrage Funds. In the first half of the 2015, Income Funds or Dynamic Bond funds (Debt funds) & Short-Term debt funds have outperformed the arbitrage funds thanks to the interest rate cuts.
·         Though these funds are treated as Equity funds w.r.t. taxation, they may not generate returns like equity funds in the long-term.
·         If you are looking for a tax efficient investment option for short term goals (1 to 2 year goals), you can consider investing in arbitrage funds.
·         You can invest lump sum amounts in these funds for short-term goals. Systematic Investment Plan (SIPs) in these funds may not really make sense.
·         You can consider these funds as one of the saving options when you are building your emergency fund.
·         When your Financial Goal Target Year is nearing, you can switch from high risk investment options to these funds which have low-risk & are tax-free (more than 1 year).
·         These funds have a very remote chance of generating negative returns. Even in 2008 when stock markets crashed, arbitrage funds gave positive returns in India.
·         As these are risk-less opportunities, the returns may not be double digits.
·         Arbitrage Funds can be a better choice if you are in the tax slabs of 20 to 30%, when markets are very volatile and when the interest rates are stable or increasing.
·         Do watch out for Exit Loads of these funds. They can be higher than the debt funds.
·         Arbitrage Funds are not allowed to SHORT in Cash Markets in India. So in a bear market their performances can suffer.
These funds have high turnover and high transaction costs. (If a fund has 100% turnover, the fund replaces all of its holdings over a 12-month period. This is known as Turnover Ratio.)

Volatility is the name of the game

Volatility is good news for investors in arbitrage funds as their returns go up during periods of market turmoil. This is because arbitrage funds generate returns by harnessing the price differential between the cash and futures market— they buy in the cash market and sell in the futures market. This cash-futures difference widens during volatility. Of late, average absolute returns from arbitrage funds have jumped and in September 2018 it was at 0.7514% (9% annualised). Average returns have jumped from 5.79% in September 2017 to 9.02% in September 2018.Two factors contributed to this jump. First was the increased volatility in the market. Experts feel returns from this category will be strong in the coming months as well. Increased volatility will continue till the general elections in 2019 and arbitrage funds should continue to generate good returns. Increased currency volatility and high hedging cost of dollar is the other reason. The rupee has already weakened to 74 – 75 per dollar and experts do not see further depreciation. However, that does not mean that FPIs will come back with a bang, because the currency hedging costs would remain high for some more time. However, the additional returns from this factor may not last till May 2019—FPIs will come back once currency hedging costs stabilise, reducing arbitrage opportunity for domestic funds. Investors should thus moderate their return expectations. The returns generated in the last 1-2 months were high and investors should not expect similar returns for the full year. Exit load can eat into short-term returns. These schemes cannot be substitutes for liquid investments. 

Answers to pertinent questions

Who should invest?
Arbitrage funds are useful for investors with low risk appetite. However, investors who want to get into this segment should also realise that its NAV volatility can be very high in the short term. This is because the scheme will be forced to value both their buy and sell positions on a mark to market basis. Though locked-in profit will be realised finally (when the arbitrage trade is finally settled), this valuation method, may force it to report short-term losses if the gap widens in the middle. Arbitrage funds are suited for educated investors, who understand how they work. They also need to understand that returns will be high during high volatility periods and will be low during low volatility.
Safe haven
Arbitrage funds make money from low-risk buy-and-sell opportunities available in the cash and futures market. Their risk profile is similar to that of a debt fund. In fact, many arbitrage funds use Crisil BSE 0.23% Liquid Fund Index as their benchmark. These funds are tailor-made for investors who seek equity exposure, but are wary of risks associated with them. Arbitrage funds become a safe option for the risk-averse individuals to park their surplus money, when there is a persistent fluctuation in the market.
Taxation advantage
Though they offer debt-like returns, arbitrage funds are treated as equity funds for taxation purposes. While the taxation advantage is less now after the imposition of long term capital gains tax and dividend distribution tax, they still offer an edge if you park funds for short to medium durations. Since the risk here is low, people can shift their debt fund investments to arbitrage funds for better post tax returns.  Arbitrage funds offer a tax advantage and therefore, the post tax returns are better. However, your holding period is critical. Arbitrage funds are good if your holding period is less than three years. This is because three years is the cut off between short-term capital gain (taxed at your tax slabs) and long-term capital gain (taxed at 20% after allowing indexation benefits) in debt funds. 
Growth or dividend?
This is the next question investors need to answer once they decide to go with arbitrage funds. Investors with a holding period of up to one year can go with the dividend option. They can opt for the growth option if their holding period is between one and three years. 
Exit load
Since NAV movements can be volatile within monthly derivative cycles, fund houses usually charge small exit loads for redemptions within a month. Investors should not use equity arbitrage funds as a substitute for liquid funds to park money for a few days. 
Why is there higher investor interest in arbitrage funds? 
There is higher interest amongst investors in arbitrage funds ever since the long-term holding period for debt funds was increased from one to three years. Since arbitrage funds maintain an average exposure of more than 65% to equity, they are treated as equity funds, their holding period for long-term capital gain is one year. From the start of April 2018, long-term capital gain from equity is taxed at 10%. 
Is Arbitrage safe strategy for investors?
Wealth managers point out that arbitrage funds rank high in the pecking order when it comes to safety. The fund manager creates a market neutral position by buying in cash market and selling in futures. Higher the volatility, higher the opportunities. With elections around the corner, volatility will increase and hence they are a good bet. 
What returns have these funds generated in the past?
Returns from arbitrage funds depend on arbitrage opportunities available between the spot market and the futures market. Such opportunities are high in bull markets. As the assets under management in this segment increase, all this money will be chasing similar arbitrage opportunities and hence returns could be lower. Over the last one year, this category of funds has given an average return of 5.65%. Over a three year period investors have earned a return of 6.10%.  The current FD rates for 1 to 2 year tenure are around 6 to 7%. But Arbitrage funds are more tax efficient than FDs. So, if you are planning to invest in FDs (time deposits) for short term, you may still consider investing in Arbitrage Funds. Arbitrage funds have given average returns of 5 to 6% in the past one year, while liquid and short-term funds have given around 6.5% and fixed deposits have yielded 6.75%. Investors in the 5% tax bracket might not find this very attractive, but those in the 20% and 30% tax brackets certainly will. In the 30% tax bracket, the post-tax yield of debt funds will be around 4.5% while bank deposits will give roughly 4.75%.  

If you look at the returns of arbitrage funds, they do not seem very attractive when compared to the pre-tax returns of liquid funds or short-term debt funds. However, it is the tax implication that makes the difference. When considering the 1-year returns, the gains on arbitrage funds are tax-free. However, returns on liquid funds and short-term debt funds attract a tax rate of nearly 36% if you fall in the highest tax bracket. In most of the periods, Arbitrage Schemes outdid the debt fund benchmarks, if we consider the taxability as per the current rules. Thus, for short-term investments, arbitrage schemes are a clear winner. For investments greater than three years, indexation kicks in. Thus, the effective tax rate would be lower than 20%. Hence, debt schemes may be able to deliver a better post-tax return as compared to arbitrage schemes. On considering the past three-year returns on a yearly basis, we can see that debt fund indices have clearly outperformed the average arbitrage fund. Individual debt schemes would have performed much better. However, in a couple of three-year periods ending September 2012 and September 2013, arbitrage schemes performed marginally better than their debt fund counterparts. From the above analysis, we can say that arbitrage schemes are an apt choice if your holding period is less than three years. The difference in taxation makes a significant transformation in the net returns. Like with all investment avenues, you need to choose wisely.