FUND FLAVOUR - ARBITRAGE / DERIVATIVE FUNDS

FUND FLAVOUR

Arbitrage / Derivative Funds

Imbalance to combat insecurity!

Derivatives are instruments whose value is derived from the value of one or more underlying assets. The most common underlying assets include stocks, commodities, precious metals, market indices etc. Some of the common derivatives are forwards, futures, options and swaps. Fundamentally, derivatives are instrument for hedging purposes, but they can be used for speculative purposes too. Arbitrage Funds or Derivative Funds are recognised for modest and secured returns across the world and are comparatively safer investment options when compared with equity funds.

Arbitrage, in financial parlance, is the practice of taking advantage of a state of imbalance between two or more markets i.e. it involves buying and selling of equal quantities of a security in two different markets with the expectation that a future change in price in one market will be offset by an opposite change in the other. One of the markets is usually cash or spot, while the other is derivatives.

The modus operandi

Position in a stock is created in the spot or cash market and a reverse position in the same stock in the futures contract (a contract which obligates the buyer to purchase or seller to deliver at a future date at a determined price). Let us consider an example. If the price is higher in futures market than the spot market, the fund will buy the stock in spot market and sell it in equal quantity in the futures market simultaneously. To illustrate, if the price of a stock is Rs 100 in the spot market and the month end future price is Rs 120. The scheme would enter into the following trades: Purchase 1000 shares (Rs 100 per share) at the total cost of Rs 1 lakh and sell 1000 futures of the same stock (Rs 120 per share) at the sale proceeds of Rs 1.2 lakh. The trade is done to lock in profits of Rs 20000 irrespective of the movements in the stock price. Also let us assume that the price of the stock has gone down to Rs 95 by the end of the month. That would mean a loss of Rs 5000 {1000* (95-100)} in the spot market and a profit of Rs 25000 {1000*(120-95)} in the futures market. That is a net profit of Rs 20000 for the scheme. Alternatively, if the price goes up to Rs 125, that would result in a net profit of Rs 25000 {1000 * (125-100)} in the cash market and a loss of Rs 5000 {1000*(120-125)} in the futures market. That is again a profit of Rs 20000 for the scheme. By doing this fund is insulated against price variations in the stock prices in both cash and derivative markets.

The return of the fund is, thus, linked to the extent of arbitrage opportunity regardless of what direction and to what extent the market rises or falls. Though it cannot generate the kind of returns that an equity fund can, it will not give negative returns either.

The fledgling Indian market…

Pioneered by Benchmark Derivatives in December 2004, a little more than a dozen derivative funds have made their appearance in the Indian Mutual fund scenario in the past three years, with HDFC Arbitrage Fund being the latest offering.

The Law Point…

SEBI allows full-fledged participation of Mutual funds in derivatives trading. Earlier, they were permitted to participate in derivatives market for the purpose of hedging and rebalancing their portfolios only. The Mutual Funds are considered as trading members like registered FIIs and their schemes are treated as clients like sub accounts of FIIs. Appropriate disclosures are made in the offer document regarding the extent and manner of participation of the schemes of the Mutual Funds in derivatives and the risk factors. Earlier there was a stipulation that the maximum derivatives position a fund could take was 50 per cent of its asset size. Now there is no restriction on the amount arbitrage funds can invest in derivatives. They can engage in arbitrage activity upto 75-80 per cent of the asset size. The tax treatment for a derivative fund is similar to that for an income fund. For the growth option, long-term capital gains is zero, while the short-term capital gains is 15 per cent. For the dividend option, the dividend distribution tax is 14.125 per cent plus surcharge. Those who hold for over a year are eligible for indexation benefits.

The attraction…

Every portfolio should have some asset allocation to an arbitrage fund. That is because, it is virtually a risk- free product, completely hedged at all times and hardly impacted by the volatility in the markets.

The advantages of using derivatives, as an investment strategy over cash markets is that the fund outlay in a derivative contract is lower. Typically, only a percentage is to be paid upfront in the shape of initial margin. Thus, for the same fund outlay, much larger exposure is possible through a derivative contract.

Since such funds come under the category of equity funds post tax returns enhances in such funds compared to the debt funds.

The repulsion…

There is no denying that such funds provide good hedge against volatile markets but the concern is that investment opportunities catering to the mis-pricing of securities in different markets to generate returns may be few and difficult to spot and would require the fund managers to be very active.

Simultaneous trade in various markets which may increase transaction cost and portfolio turnover rate.

In a period when no or few arbitrage opportunity is available, the fund will have to rely upon the fixed income instruments which may dampen the returns. Moreover, arbitrage activity in India is largely concentrated in some of the stocks.

The magnetism unleashed…

Extending the basic fundamental features of mutual funds to various forms of investments through innovative measures has remained the specialty of mutual funds and is a good sign for any industry to evolve. With SEBI allowing the full-fledged participation of mutual funds in derivatives and recent turbulence witnessed in the equity markets, fund managers are now hunting grounds with arbitrage funds and rightly so as such these funds provide risk free returns least affected by the market movements and suffices the needs of conservative investors. As a category, derivative funds have turned in superior returns as compared to other debt categories. As these funds are centered on price difference between the spot and futures markets such price differences provide huge opportunities for generating returns from equity without taking the risks involved in equity investments.