GEM GAZE
March 2010

Advantage Arbitrage

The derivatives markets account for around Rs 60,000 crore and arbitrage mutual funds manage around Rs 3,000 crore. This leaves enough space for mutual funds to reap the benefits of the available arbitrage opportunities. Arbitrage Funds make the most of the difference across markets by investing in cash and futures market in a diversified basket of equity & equity related instruments, derivative and debt and money market instruments in accordance with asset allocation pattern. Arbitrage funds can be liquidated any time or once a month in some cases. Moreover, the dividends are totally tax free and both the principal and dividend are fully and freely repatriable too.

Arbitrage Funds that have stood the test of time and retained the glittering glory and the much sought after status of a GEM in 2010 have been exhibited below.

UTI Spread Fund Gem
Energy sans expense

One of the best performing arbitrage funds, this Rs 500 crore fund was a category topper in 2008 with a return of 10.60 per cent. Right from January 2008 till March 2009, the fund had outperformed the category average. That is definitely a reward for its bold stance that often goes against the general market trend. The one-year return of the fund in 2009 is 5.5%, way ahead of the category average return of 3.82%. An expense ratio of a mere 1% is a jewel in the fund’s crown. The top three sectors account for 37%, with construction and energy occupying the top two slots. Investment in equity is at 73% with debt constituting a mere 16%.

HDFC Arbitrage Fund Gem
Formidable fortress

Fortitude in a falling market has been the fund’s forte. If we look at the period from January 2008 to March 2009, the market had been in the red for 10 months. Overall, during 11 of these 13 months, the fund had outperformed the category average. On the other hand, in the year 2009 when the market closed in the green, the fund has been able to beat the category average. HDFC Arbitrage Fund has returned approximately 3.91% in the last one year as against the category average of 3.82%. The expense ratio is a paltry 0.82%. This Rs 245 crore (Rs 742 crore in the case of wholesale fund) fund has a penchant for the financial sector with energy being accorded the next preference. The top three sectors account for 32% of the total assets. 63% of the assets are invested in equity instruments while 29% of the assets are invested in debt instruments.

Kotak Equity Arbitrage Fund Gem
Consistent and flexible

Two factors stand out in favour of this Rs 727 crore fund. It has been a consistent player in this category and its expenses have always been on the lower side. Its one-year return of 4.48% in 2009 is well above the category average. Its expense ratio is 1.05%. This fund is very flexible in its approach. It has no market capitalization bias while looking for arbitrage opportunities. It started as large-cap fund but now has around 83 per cent in mid- and small-caps. In adverse market conditions, the fund has the leeway to go 100 per cent in debt. Though it not done so, since launch it has, on an average, maintained a 41.70 per cent exposure to debt. The exposure to debt at present is 33%. Currently, equity exposure is nil.

JM Arbitrage Advantage Fund Gem
Solid but expensive

The fund, sporting an AUM of Rs 497 crore, has been a solid performer delivering above average returns. The one-year returns have been 4.1% as against the category average of 3.82%. This fund is betting big on the technology and financial sectors and has allocated around 34 per cent of its holdings to the top three sectors. The fund has allocated 68% of the funds to equity and 23% to debt. 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.

SBI Arbitrage Fund
Mediocre mountain

Though it boasts of an asset base of Rs 470 crore, its performance is just about average. One-year return is 3.83% as against the category average of 3.82%. The fund manager moves in and out of sectors frequently and does not hesitate in taking concentrated sector bets. Financial services, for instance, had an allocation of 31.50 per cent in August 2007 which dropped to 19.88 per cent the very next month. Between January and February 2008, the allocation rose from 7 per cent to 20.42 per cent. It was the same in energy where the allocation moved up from 12.64 per cent (November 2007) to 24.44 per cent (December 2007) and down to 17.25 (January 2008) and back to 12.74 per cent (February 2008). At present, energy and construction are the top two sectors with the top three sectors occupying 37% of the total assets. Although the fund's mandate limits its debt investment to 35 per cent, in the months of September and October 2008 the average allocation to debt stood at 63.39 per cent. Right now, the percentage allocated to debt is 29% with 67% being invested in equity.

Going that extra (1% return) mile!

Arbitrage Funds give an extra 1% return over the risk-free rate of returns, just by playing the differences in the cash and futures market. But why would one invest in these funds? Especially at a time when the markets are bullish and corporate earnings are in line with the expectations. This is a question that comes straight from the books on behavioural finance. Investors get the feeling that arbitrage funds are completely risk-free even when compared to any kind of debt funds. Most of the investors are institutional or corporate investors and look at risk and return differently than retail investors. Corporate investors prefer these funds to retail investors as their mental heuristics are strongly biased towards that extra 1% return - something that a retail investor would easily let go.