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.