FUND FULCRUM - MARCH 2009

FUND FULCRUM (contd.)
(March 2009)

Regulatory Rigmarole

A good 16 years after it first started taking shape, India is just a day away from finally having a pension system that is meant for private individuals. From April 1 2009, any individual will be able to start a New Pension System (NPS) account with designated 'point of presence' (POP) and start saving up for a pension. Of course, the system is not just for private individuals. The pension of all central government employees who have joined service after January 2004 are also part of NPS. The design of the new system is simple. The POPs will be the front end, the National Security Depository Limited (NSDL) will be the record keeper and six mutual fund houses - UTI Retirement Solutions, SBI, ICICI Prudential Life Insurance, Reliance Capital, IDFC AMC and Kotak Mahindra AMC - selected by the Pension Fund Regulatory and Development Authority (PFRDA) will be the fund managers. The fund managers will run different plans that comprise of equity, government securities and corporate bonds. The distinguishing feature of the NPS is the extremely low cost. The annual cost of record-keeping is Rs.380, each transaction costs Rs.6 and the most amazing of all-the investment management fee is 0.009 per cent per annum. But NPS takes a severe beating on the liquidity, tax and legal fronts. Liquidity is very low - you cannot withdraw the money till you are sixty years old, except for critical illnesses and for building or buying one house. Even at sixty, only 60 per cent of the corpus can be withdrawn as cash. The rest must be used to buy an annuity. The gains will be treated as taxable. With the PFRDA Bill yet to be approved by Parliament, the pension watchdog’s punitive powers have been restricted as compared to other regulators such as SEBI or IRDA.

SEBI has invited public comments with regard to variable load structure, whereby, the investor and advisor — also called distributor or broker — would mutually decide on the fee, instead of the flat 2.25% entry load as is the norm now. At present, mutual fund distributors are paid a commission by the fund company. This commission is deducted from the investment that the investor has made. The quantum of the commission is a matter between the distributor and the fund company. The new rules envisage a system under which the distributor and the investor will negotiate and decide upon a commission. The payment will be made either directly by the investor to the distributor or through the fund company. Regardless of the route of the payment, if these proposals are implemented as rules, there will be free pricing which will be negotiated between the two parties. Understandably, going from the current administered pricing regime to free, negotiated pricing is a scary prospect for distributors. At present, AMCs pay a commission of anything between 50 basis points and 3.5 per cent to their distributors. This commission is over and above the 2.25 per cent entry load that is paid by investors. As distributors' commissions vary according to different schemes and fund houses, investors are often kept in the dark regarding this payment. As a result, it becomes difficult to ascertain whether the advice a distributor renders is in the genuine interest of the investor, or if it is influenced by the amount of commission he is paid by the AMC. If implemented, this move will bring a paradigm shift for the mutual fund industry.

A better way to bring investment transparency is by standardising — and making it public — commission charges across investment products. A few fund sellers are also lobbying for multiple share-classes load structures that are popular in the US. Such schemes allow investors to select the fee options from broad categories like higher entry load-but-low annual charges, low annual charges-but-higher entry load and such other cost combinations. Transparency is needed in the mutual fund industry. But multiple no-load or low-load options may lead to lack of interest on the part of advisors to recommend good schemes to investors. Customer-agreed pricing structure might prompt distributors to push non-mutual fund products, which do not publicise intermediary cost - ULIPs offer distributors 20-40% commission, corporate fixed deposit schemes yield 1.7-2.5% or even RBI tax-relief bonds give 1% as commission charges.

The High-Level Committee on Capital Markets will introduce uniform norms for investment advisors across banks, brokers and agents. The new norms will include the areas of commissions, certification and disclosures. The investment advisory business that runs into thousands of crores every year is in a mess because of regulatory overlaps. Banks are regulated by the Reserve Bank of India, the insurance agents are regulated by the Insurance Regulatory & Development Authority (IRDA) while mutual fund agents are regulated by the Securities and Exchanges Board of India (SEBI). A year-and-a-half ago an attempt was made to bring them all under one common jurisdiction — the then IRDA Chairman CS Rao was asked to head the committee but not much progress was made. Rao subsequently retired and now the High Level Capital Market Committee — headed by the RBI Governor — has taken over.

SEBI has delivered the latest instalment in the wave of reforms that have swept over mutual funds after the liquidity crisis in 2008. Earlier, the regulatory agency has fixed some of the obvious problems that contributed to the liquidity crisis - NAVs based on illiquid investments, closed-end funds which allowed premature redemption and long maturities in liquid funds. Now, SEBI is cleaning up the funds’ portfolio revelations. SEBI has issued a circular stating a new format to AMCs for disclosing the portfolio of debt oriented close-ended and interval schemes/plans on a monthly basis on their respective websites in order to enhance the transparency of portfolio. The new disclosure of the portfolio as on the last day of the month shall be made on or before the 3rd working day of succeeding month. For example, portfolio as of 31 March 2009 shall be disclosed by 4 April 2009 - 3 April 2009 being a non working day.

In their portfolio declaration, funds generally list the name of a security and the quantum of their investment in it. There can be more information, but this is the core set that is always there. For equities, this is quite enough. However, in the case of debt, the very identity of a debt security is difficult to determine. For starters, the same company can—and normally does—issue many different debt securities. Unlike equity, there is no standard nomenclature that can identify and differentiate between these. Worse, the lack of a standard nomenclature means that the same security could appear under different names in different funds’ portfolios. This has grave implications for investors. As things stand now, investors cannot reliably combine the portfolios of different debt funds and see what their combined exposure to a given security or borrower or sector is. SEBI’s new rules mandate a richly detailed format for declaring debt portfolios that takes care of all these problems. This is a huge step forward in bringing transparency to individual funds’ portfolios. However, they are not a complete solution for investors. Debt investors need to easily aggregate their holdings across different funds to be able to analyse their risk exposure without doing heavy detective work. This need can only be met by each security having a specific identification symbol that is universally recognised. Such a system already exists and is called the International Securities Identification Number (ISIN). In India, ISINs are there for many but not all debt securities. The logical final solution for the declaration of all investment portfolios, be they of mutual funds or insurance schemes or anything else, is to make them purely ISIN-based. This will work for equities and also for international holdings because the ISIN system is global.

According to a Merrill Lynch Survey of 213 Fund Managers who manage US$ 533 billion in investments, investors are optimistic about the global economy since December 2005 but, the prolonged banking crisis seems to be stopping them from putting cash into equities. The survey reveals that for the first time in more than three years, investors do not predict lower global economic growth over the next 12 months. The renewed optimism about China`s economy lies at the heart of this revival. Just two months ago, a net 70% of respondents thought China`s economy would worsen in the year ahead. That figure fell to a net 1% this month. Though respondents were noticeably bearish about Japanese and Eurozone equities, the survey in March shows signs that investors want to believe in an economic recovery.

FUND FULCRUM
(March 2009)

The mutual fund industry in India regained the Rs 5,00,000 crore-mark in assets, after a gap of four months. The combined average AUM of the 34 fund houses in the country shot up to Rs 5,00,973.37 crore in February 2009 as against Rs 4,60,948.99 crore in January 2009, as per the data released by the Association of Mutual Funds in India (AMFI). The total AUM of the mutual fund industry increased by Rs 40,000 crore or 8.8 per cent. The total AUM of the industry in September 2008 was Rs 5,28,871.75 crore. However, in October 2008 the assets had dipped below the Rs 5,00,000- crore mark, which had continued from November 2008 to January 2009. Reliance Mutual Fund maintained its top position. HDFC Mutual Fund gained Rs 5,443.66 crore in its AUM at Rs 56,864.39 crore. ICICI Prudential's AUM stood at Rs 53,514.07 crore at the end of February while UTI Mutual Fund had assets of Rs 49,224.93 crore after an addition of Rs 5,998.57 crore and Rs 3,063.53 crore, respectively. Franklin Templeton Mutual Fund saw an increase of Rs 100 crore in its AUM of Rs 1,9407.80 crore, in February 2009.

Fund flows into mutual funds in recent months, have shown a strong correlation to performance and size of fund houses. Large fund houses, with a large number of better performing funds in line with the CRISIL Composite Performance Ranking (CPR) of mutual funds are attracting higher inflows according to a study by Crisil. The top three fund houses, which recorded the highest increase in absolute AAUM over January and February 2009 have a large number of funds which fall in the CRISILCPR 1 (very good) and CRISILCPR 2 (good) ranking clusters and are large in size. With equity markets still volatile and the economic climate uncertain, the AAUM growth currently is driven mainly by debt and liquid funds. Corporate bond yields fell in February 2009 and in such an environment, debt funds held an edge with respect to returns.

A large cap bias, low cash levels and an investment path which is different from the routine herd investment strategies appear to have worked in the current scenario. The funds that do well are disciplined and they do not rely on a particular skill set of a particular individual. They are as concerned about the risk matrix of a portfolio as they are about their return potential. Public sector fund houses seem to be the preferred choice for mutual fund investors at present.

Reliance Mutual Fund has been awarded the ``India Equity Fund House`` for the year 2008 by Morningstar India. The award has been given for delivering sustained performance on a risk-adjusted basis across their fund line-ups in the equity category for period ending December 31, 2008.

ICICI Prudential Monthly Income Plan (Monthly Income is not assured and is subject to availability of distributable surplus) paid its 100th consecutive dividend in February 2009. The fund has accomplished an unparalleled feat and has not missed a single dividend payment since its inception in November 2000. The fund, true to its mandate, has paid 100 consecutive dividends since its inception in November 2000. The fund has maintained optimal asset allocation to ensure regular monthly dividend payouts despite 2008 being a down beat year.

Piquant Parade

India Infoline Ltd, a domestic financial services major, is planning to float an Asset Management Company and is focusing on non-broking activities in the financial services segment to protect its revenues during the crisis.

In an attempt to give investors the best of both worlds, mutual fund houses have begun offering flexible asset allocation plans that allow unitholders to keep increasing their exposure to equities while starting off in a debt fund. These funds, which essentially bear resemblance to dynamically managed funds, allow investors to balance their investments in favour of equities while gaining advantage of the current interest rate trend through investment in fixed income. Also known as ‘switch options’ in distributors’ parlance, these plans help investors to move money steadily into equity funds. While ICICI Prudential MF, through ICICI Prudential Income Opportunities Fund- systematic transfer plan STP, and HDFC MF, through HDFC Flexindex Plan, have already launched switch plans, UTI MF will soon launch a fund that will enable investors to shift investments across debt and equity schemes.

All is not well between Punjab National Bank and Principal and their asset management joint venture. The joint venture between Principal Financial Group and PNB is on shaky ground. Principal holds 65% and PNB owns 30% in the asset management company. Major differences have cropped up and a clash in values has triggered PNB to make an exit from this partnership. But what is holding PNB back is the poor market conditions. The total assets under management for Principal-PNB AMC as of February 2009 stand at around Rs 7,000 crore. Principal is offering PNB Rs 100 crore for its 30% stake in the AMC. But, PNB wants more - close to Rs 150 crore.

The abrupt resignations of senior investment officials at a couple of AMCs recently could turn the spotlight on some of the ‘deals of convenience’ struck between promoters and fund managers during the latest boom. Such transactions, mostly involving mid-sized companies, helped promoters boost valuations of their firms while the fund house gained by way of inflows into its equity schemes.

With the uncertainty over general elections looming large, mutual funds are taking positions to counter any market volatility till a new government comes in place. Some fund houses are looking at conservative sectors which are less impacted by market trends and maintaining a cash level of 10-20 per cent in their equity schemes. Election is perceived to be the biggest domestic event that could dent markets in 2009. Already bruised by the global recession, cautious fund mangers are taking investment calls. FMCG, pharma, infrastructure, oil and gas, agriculture and auto have emerged as the preferred sectors to counter any sudden market volatility from the election results. Mutual funds are looking at low beta and low correlation (to broader market) stocks. These stocks chart their own course with less impact from broader market conditions. Hence, they will act as a cushion against any uncertainty.

To be continued…

NFO Nest
(March 2009)

Of mean markets and pompous products…

Since April 2008, about 290 offer documents were filed with SEBI, according to the Delhi-based mutual fund tracker Value Research. During October 2008, the Sensex fell to a low of 7,700. Since then, there has been some recovery. But markets continue to languish. The more recent new fund offerings have managed to garner only minimal amounts due to low investor appetite. But debt funds are getting inflows into their fixed income and liquid schemes. It is no wonder that fund houses have deferred launches, despite approvals being given to around 40-45 schemes. The adverse market conditions apart, pending responses to queries from SEBI and a change in guidelines have also been contributory factors to the lull in the NFO market. Out of the 183 schemes for which offer documents were filed since October 2008, 68 schemes were fixed maturity plans (FMPs) that had to be shelved because of a change in guidelines in the third quarter of 2008-09. Of the remaining 115, SEBI is yet to approve around 70-75 schemes.

SEBI is not comfortable with structured products. SEBI has expressed its discomfiture with schemes that are based on equity-linked debentures (ELD) and constant proportion portfolio insurance (CPPI). These products are too complex for the lay investor. With the continued downturn in the equity markets, and ratings of ELD issuers too moving into negative zone, the products carry a risk of default. Currently, there are three ELD-based schemes that have collected Rs 1,516 crore. Four ELD based schemes — UTI Equity Linked FMP Series I, Tata Equity Linked FMP, Birla Equity Linked FMP Series 1M and HSBC Equity Linked FTP — have not yet received SEBI’s approval. ELDs are floating rate debt instruments whose coupon (interest) is based on the return of the underlying equity index, like the Nifty. However, if the issuer of ELD defaults, the investor bears the risk of losing a part of the principal. There are no CPPI products for retail investors.

The following funds find their place in the NFO Nest in March, 2009.

Taurus Ethical Fund

Opens: 19 Feb, 2009 Closes: 30 Mar, 2009

Taurus Ethical Fund, an open-ended equity-oriented fund, is the first actively managed product in the Indian mutual fund space that conforms to the principles of Shariah investing. It is benchmarked to the S&P CNX 500 Shariah Index. The fund will refrain from investing in sectors or companies that are not compliant with Shariah principles- banks and financials, tobacco, breweries, alcohol related chemicals and meat processing. The fund will also apply additional company-specific filters to weed out companies that are high on debt or interest outgo, in keeping with the Shariah principles. The three financial filters are: Total debt/total assets less than or equal to 25 per cent, cash/receivables/total assets less than or equal to 90 per cent and interest income/total income less than or equal to 3 per cent. These filters will make the fund’s investment universe more restricted as compared to a plain vanilla diversified fund. But Shariah-compliant stocks account for roughly half of the market capitalisation and turnover on the NSE. Roughly 260 of the CNX 500 companies and 40 of the 50 CNX Nifty companies feature in the respective Shariah indices of the NSE. This suggests that this fund will have access to a sufficiently large universe to deliver good diversification. In fact, this fund’s investment universe will be much larger than that of most theme funds.

It is difficult to arrive at the return prospects of this fund, given the lack of comparable products with sufficient history. However, in the global context, Shariah-compliant funds have outperformed broader market indices over the past two years. This performance is clearly explained by their complete avoidance of financial stocks and highly leveraged companies, which have borne the brunt of the credit-triggered global financial crisis. Such out-performance may not be sustained at all times. In fact, the fund’s basic tenet of avoiding highly leveraged businesses and leaning towards those with relatively high cash, would tilt the portfolio towards mature businesses with moderate growth prospects. This may make such a Shariah-compliant portfolio a suitable option for conservative, rather than aggressive growth-seeking investors. A Shariah-compliant portfolio may also carry a valuation premium to the market today, given that over the past year stock market investors too have gravitated towards precisely such companies.

The scheme has been certified by an independent Shariah Board, Taqwaa Advisory and Shariah Investment Solutions (TASIS). The role of this board is to regularly monitor stock picks and certify their Shariah compliance on a quarterly basis. TASIS Shariah Board comprises eminent Shariah Scholar Mufti Barkatuallh Abdul Kadir, who is on the Shariah Board of reputed UK based banks.


Sahara Short Term Bond Fund
Opens: 12 Mar, 2009 Closes: 8 April, 2009

Sahara Short Term Bond Fund aims to generate optimal returns with moderate levels of risk and liquidity. For this purpose, it will primarily invest in debt securities including government securities, corporate debts and other debt instruments as well as money market instruments. As per its mandate, the fund can invest fully in debt and money market instruments with an average maturity of less than or equal to 12 months. It can maintain up to 50 per cent exposure in various debt instruments with an average maturity of more than 12 months. Exposure to securitized debt can go up to 50 per cent. The fund can also invest in foreign securities up to 10 per cent and in derivatives up to 50 per cent of the net assets respectively. The fund’s investment strategy would consist of various parameters such as prevailing interest rate scenario, quality and liquidity of the security, maturity profile of the instruments and growth prospects of the company whose instruments would be considered for investment. The fund will be benchmarked against CRISIL Liquid Fund Index and Mr. Devesh Thacker would be its designated fund manager.

The scheme offers attractive investment opportunity with low to medium risk profile and instant liquidity to investors at all time. Given the current scenario, this fund offers better opportunity to earn attractive returns besides having relative tax advantages.

ICICI Prudential Ultra Short Term Plan, ICICI Prudential Medium Term Plan, Mirae Asset Income Fund, Quantum PFN Equity Fund of Funds, Tata PSU’s Bond Fund, Religare Business Leader Fund and Tata Triple Ace Fund are expected to be launched in the coming months.

GEM GAZE - ARBITRAGE FUNDS

Gem Gaze
(March 2009)

Positive Pangs…

The equity market in 2008 has given a lot of opportunities for arbitrage funds and they have been able to capitalise on that. In the last 12 months, the average returns from arbitrage funds have been around 8.8%. At the same time, the best performing diversified funds lost around 40%. Even in the last six months, arbitrage funds have helped investors garner some positive returns in the equity category.

The gleaming gems in this category in the past one year are parading in the decending order of glitter…

UTI Spread Fund Gem

The sensation of 2008, this fund delivered 2.98 and 1.96 per cent in the last two quarters, respectively. The one-year return was an impressive 9.71%. UTI SPrEAD has beaten its benchmark Crisil Liquid Fund Index as well as peers over a one and two-year period. Monthly rolling returns since inception also reflect superior performance over benchmark close to 90 per cent of the times. The assets as on 28 February, 2009 was Rs. 215.73 crores. In the last six months, this fund has decreased its equity holdings substantially to 60 per cent (from 72 per cent in December 2007). If it continues to maintain its current equity-debt allocation, it would lose its status as an equity fund and subsequently not be as tax efficient. An exemplary example of ture diversification, the top 5 sectors contribute to a mere 13% to the total assets, with the FMCG sector reigning high at 9%.UTI SPrEAD has the flexibility to move in to debt when the latter offers superior opportunities. The fund has used this mandate well to invest actively in short-term debt from the first quarter of 2008 and completely moved into debt in January 2009. Most of the instruments are short-term certificates of deposits and commercial paper which were perhaps entered at higher yields. However, with the yield curve now softening, the fund may find less attractive short-term instruments in the markets. This may lead to a shift towards equity arbitrage once again in the upcoming months.

HDFC Arbitrage Fund Gem

Launched in October 2007, the net assets stand at Rs. 99 crores (Retail Plan) and 173 crores (Wholesale Plan). Benchmarked against the Crisil Liquid Index, the one-year return of the fund (Retail Plan) surpasses the category average of 7.25% by 0.4%. This is a better performance vis-a-vis its peers considering the fact that it has been in existence for only a year. The performance of the Wholesale Plan is a tad better at 7.87%. At 14%, the top position is occupied by the financial sector with the top five sectors sharing a generous 42%, indicating a high level of concentration.

ICICI Prudential Blended Plan Gem

With net assets of Rs. 90.89 crores on 28 February, 2009 the one-year return of the fund was 7.69% as against the category average of 7.25%. It is benchmarked against the Crisil ST Bond Index. 46% of the funds are allocated to the banking sector with 9.51% being accounted for by the shares of Oriental Bank of Commerce alone. 68% of the total funds went into equities with the rest being allocated to the money markets.

JM Arbitrage Advantage Gem


The fund has been a solid performer delivering above average return – its one-year return was 7.57% as against the category average of 7.25%. This fund is betting big on the construction sector and has allocated around 8 per cent of its holdings to it. This may be due to the increased volatility in this sector in recent months (increased volatility creates more arbitrage opportunities). A major concern is that its expenses are growing, an indication that the fund probably trades very heavily. While trading generates returns, the downside is that growing expenses eat into returns. With net assets of Rs. 273.60 crores as on 28 February, 2009, the fund is benchmarked against the Crisil Liquid Index. Nearly 19% of the funds were allocated to the financial sector with 14% invested in J and K Bank alone. The fund is moderately diversified with the top 5 sectors accounting for 21.5% of the total holdings.71% of the funds have been invested in equities with the rest in debt.

Kotak Equity Arbitrage Fund Gem

2008 has been a not so good year for this topper of the previous year. It fell from the top position with a return of 9% to a low of 7.1% this year. This can be attributed to the high allocation to cash of 67%. Its asset size also halved to Rs. 183.69 crore as on 27 February, 2009. It is benchmarked against the Crisil Liquid Index. But two factors stand out in favour of this fund. It has been a consistent player in this category and its expenses have always been on the lower side. By and large, the fund's return has rarely deviated from the category average.

Religare Arbitrage Fund

Launched in April 2007, the size of the fund is Rs. 68.02 crores on 30 January, 2009. The one-year return of the fund is 6.9% but the Expense Ratio is excessive at 1.25% with the portfolio turnover ratio a whopping 709%. The top 5 sectors account for 20% with finance sector topping at 14%. 66% has been allocated to equity with 17% each having been allocated to debt and cash respectively.

SBI Arbitrage Opportunities Fund

With its one-year return of a mere 6.7%, it falls well below the category average. Its assets have halved in the past one year to Rs. 360.04 crores as on 27 February, 2009. The top holding of the fund is in the banking and finance sector at 12.53% and the top 5 sectors account for 34 % of the holdings. 67% of the funds are allocated to equity with 33% of the funds held in cash.

Benchmark Derivative Fund

With one of the lowest one-year return of 6.56%, the low net assets of Rs. 16.5 crores as on 28 February, 2009 speak for itself. The fund is concentrated with 45% invested in the top 5 sectors. Financial sector occupies the top slot at 21%. Allocation to equity stands at 67%.

IDFC Arbitrage Fund

Launched in November 2007, the assets of the fund amounted to Rs. 126.28 crores on 28 February, 2009. The one-year return is the lowest at 6.21%. 42% of the assets are accounted for by the top 5 sectors with financial sector occupying the top slot at 11%. The Expense ratio is 0.65 % and the Portfolio Turnover Ratio is 66%.

Vitality in Volatility

One can invest in arbitrage funds in times of volatility. The performance of arbitrage funds are based more on market volatility than its direction. The higher the volatility, higher the arbitrage opportunity. If the market continues to remain volatile at either lower or higher levels, arbitrage funds will continue to generating good returns.

FUND FLAVOUR - DERIVATIVE FUNDS

FUND FLAVOUR

Arbitrage / Derivative Funds

Dispelling gravity…the fallout of the Law of Gravity

Everything that goes up comes down. And if you want proof of this, you need to look no further than the Sensex. After December 2007, it has kept inching up only to fall flat once again. The trick in such tricky times is in finding an asset class, which offers some protection to avoid erosion of capital. Among the 29 categories of funds in the market, the Arbitrage Funds fit the bill. These funds actually follow a very simple and age old strategy of buying low from one market and selling high on another.

Derivatives demystified…

Historically, traders used to buy goods from one country and sell them in another country at high prices. This is called arbitrage. The difference now is that such trade has become more sophisticated than before. Fund managers now take the help of computers to capture the arbitrage opportunities that may even exist for just a few seconds. These funds typically buy stocks in the spot market and sell, at the same time, in the futures market. In effect, they hedge their investments. At the time of delivery, they profit from the spread in the future-spot market. Moreover, corporate actions such as dividend declaration, buy-backs, mergers or de-mergers also provide arbitrage opportunities in the futures-options markets. The unique advantage of these funds is that though they buy stocks and futures in the equity markets, their strategy of simultaneous transactions in the spot and futures/options market make their returns neutral to the debt or equity market performance.

Reaching the pinnacle …

The first arbitrage fund was launched four years back by Benchmark. Currently, this category consists of 14 funds. Their performance during this bear run has set them apart. In 2008, these funds have offered returns in the range of 6.5-9.7 per cent outperforming both the Sensex and the equity diversified category by 34 and 40 per cent respectively. Otherwise, these funds normally give returns similar to that of fixed deposits or other fixed income schemes and are preferred by risk-averse investors. One of the reasons for the good performance of arbitrage funds is that they cashed in during the market fall in January, 2008 - they unwound their positions in the cash market which was quoting at a higher price than the futures.

Caveat Emptor!

In the midst of the hype, it is important for investors to step back and note some important points with regard to arbitrage funds.

Arbitrage funds are meant to be a long-term investment opportunity so a short-term spurt in arbitrage opportunities means very little. Fund managers will be the first to admit that attractive arbitrage opportunities are not easy to come by week after week, month after month.

If investors choose to remain invested for a shorter time frame (of less than a year) to capitalise on those limited arbitrage opportunities, they will incur short-term capital gains (assuming they have earned a profit on the arbitrage fund), which could rob them of a part of the gains. At present, short-term capital gains on equities are taxed at 15%.

To top it all, arbitrage funds enjoy an edge over debt funds mainly because of the tax benefit. Long-term capital gains on debt funds are taxable at 10% without indexation or 20% with indexation (depending on which option is lower). On the other hand, long-term capital gains on equity funds (of which arbitrage funds are a subset) are subject to STT (Securities Transaction Tax) at 0.25%. Assuming that returns from arbitrage funds are the same as debt funds or even if arbitrage funds offer a slightly lower return, the tax advantage of investing in equities means that investors in arbitrage funds have a significant edge over their debt fund counterparts.

Investors give a miss to the 2008 arbitrage fund party

Despite being the only equity-linked mutual fund category that gave positive returns in 2008, arbitrage funds witnessed a sharp drop in their AUM. When most other equity funds saw their NAVs falling by over 40 per cent, the AUM of all arbitrage funds in December 2008 dropped to Rs 2,493 from Rs 6,596 a year ago, a sharp fall of more than 60 per cent. The reason for the drop in AUM for arbitrage funds is primarily the same as the reason for the drop in an equity fund's AUM — a combination of falling stock prices as well as outflows due to redemptions. A part of this can also be attributed to some investors not being aware of the differences in the way arbitrage funds and equity funds would behave in a falling equity market. Most liquid, long and medium-term debt funds gave better returns during the period and that prompted investors and fund managers alike to park their money in these funds instead of opting for arbitrage funds. In many cases, debt funds have given over 20 per cent returns compared to the arbitrage fund category best of around 10 per cent.

Utopia in times of uncertainty!

Arbitrage funds are ideal for risk averse investors who are absolutely averse to any depreciation in their capital. Moreover, these funds are more tax efficient than debt funds, as they are treated in line with equity funds. In comparison to all other variants of funds, arbitrage funds are the least volatile. These funds usually find favour with corporations, HNIs or savvy investors who understand the equity markets thoroughly. In the case of arbitrage funds, if the market goes up by 50 per cent, these funds will give returns of around eight per cent, while if the market goes down by 50 per cent, they would still give a return of six to seven per cent. Arbitrage funds are ideal when there is no direction in the market, or in times of uncertainty. These funds do well on a short-term basis but are not preferred when a definite trend is emerging in the market. But ideally, it would always be prudent to allocate around 30 to 40 per cent of one's fixed income portfolio to arbitrage funds.

With uncertainty still haunting the market, arbitrage funds are expected to create value for investors in 2009. Arbitrage funds should more or less repeat 2008's performance in 2009. However, if such funds stringently adhere to their nomenclature, such a possibility may be curtailed at best. But building investor awareness can certainly tide over this problem.