FUND FLAVOUR

March 2020

Arbitrage/Derivative Funds

A misperception about mutual funds among many retail investors, especially less experienced investors is that, these are risky investments. You should know there are several types of low risk mutual fund schemes where you can deploy your money productively (higher rate of return) instead of keeping it idle in your savings bank account. These schemes offer high liquidity and a reasonable degree of capital safety. Overnight funds, liquid funds, ultra-short duration funds and arbitrage funds are the lowest risk mutual fund products. Our focus here will be on Arbitrage Funds.

What are Arbitrage Funds?

Arbitrage funds are hybrid mutual fund schemes which aim to generate risk free profits by exploiting price differences through simultaneous buying and selling of the same underlying asset (equities, commodities, currencies etc.) in the cash and derivatives markets. These funds capitalize on market inefficiencies and profits depend on volatility of the assets. Arbitrage Funds are usually bought in the cash market and sold to futures markets to earn maximum returns from price differences of current and future securities. In financial parlance the term arbitrage denotes risk-free profits. These mutual fund schemes have a low risk profile and their returns generally reflect short term post tax money market yields. These funds are treated as equity or equity oriented funds from a taxation standpoint. As per re-categorization norms, an arbitrage fund will follow the arbitrage strategy and invest at least 65% of its total assets in equity and equity related instruments as per the mandate under normal and defensive conditions. It will also allocate the remaining assets to debt and money market instruments.

How do Arbitrage Funds work?

The arbitrage fund makes a profit out of the pricing difference in two different markets of the same security. Let us understand how these two markets work. The cash market is commonly known as the stock market. The price of a security in the stock market is called the spot price. Futures market is a derivative (a financial security dependent on underlying assets and derives its price from fluctuations in assets) market and it features only the expected future price of the securities. To trade a security for an expected future price, an investor will have to enter into a futures contract for a future date. The future date is called the maturity date. The securities are transferred to the investor at the maturity date of the contract. On the maturity date, the transaction takes place at the price agreed while entering into the contract.

The most common arbitrage strategy is to exploit the price difference of an underlying security (or index) in the cash and derivative segments of the stock market. Let us assume that a stock is trading at Rs 100 in the cash market and for Rs 102 in the F&O (Futures & Options - derivatives) market. You can lock in risk free profits by simultaneously buying shares of the stock in cash market and selling same number of futures in the F&O market. On expiry of futures, last Thursday of the month (depending on the F&O series), the cash (spot) price and futures price will converge. This strategy is totally market neutral as explained below.

On expiry of the futures the market value of your long (cash) and short (futures) position will be equal in value irrespective of the direction (up or down) of price movement since the initiation of the trades. Let us assume on expiry of your futures, the settlement price is Rs 105. You will make a profit of Rs 5 / share in the cash market and a loss of Rs 3 / share in the F&O market – your profit will be Rs 2 / share. If the settlement price is Rs 98, then you will make a loss of Rs 2 / share in cash market and a profit of Rs 4 / share in F&O market – your profit will again be Rs 2 / share. Please note that, fund managers may not wait till expiry to square off their trades. They may square off before expiry depending on the price difference and profit making opportunity. However, when more and more people begin trading in arbitrage funds, the spread between cash and future market prices reduces, which could possibly leave little for the investors.

Arbitrage Funds versus other low risk funds

We will compare arbitrage funds with other low risk funds on the following parameters.

Capital safety: Arbitrage funds offer one of the highest degrees of capital safety compared to several other low risk funds because these funds have no credit risk. Liquid funds and ultra-short duration funds invest in securities which have credit risk. As per SEBI regulation put in place earlier this year, liquid funds and ultra-short duration funds have to mark to market prices of securities. If the credit rating of a security gets downgraded, then the price of the security will fall irrespective of the residual maturity of the security. We saw NAVs of several liquid funds falling, when the credit ratings of their underlying securities were downgraded or when the issuer defaulted. Arbitrage funds and overnight funds have no credit risk. While overnight funds are the safest investment options, arbitrage funds also offer high degree of safety provided you have investment tenures of 3 to 6 months or longer.

Volatility: Though arbitrage funds follow market neutral strategy, these funds can be volatile in the very short term (prior to expiry of futures). Depending on the futures series (current, next month or the month after), futures premium (difference between futures price and cash price) may expand or shrink or even turn into a discount depending on market conditions. However as explained earlier, arbitrage is market neutral over the entire tenure of the trading strategy. The volatility (standard deviation) of monthly returns of liquid (0.26%), ultra-short duration (0.71%) and arbitrage funds (0.53%) over the last 3 years shows that arbitrage funds are more volatile than liquid funds, but are usually less volatile than ultra-short duration funds.

Liquidity (for investors): Redemption proceeds for debt fund units are paid out (credited to your bank account) in 1 – 2 business days, while that of equity oriented funds (including arbitrage funds) are paid out in 3 – 5 business days. Overnight, liquid and ultra-short duration redemptions are usually processed in 1 business day. Exit loads (charge for redemptions before a specified period depending on the scheme) differs from scheme to scheme even within the same category. Overnight funds and liquid funds have no exit load; arbitrage and ultra-short duration scheme can charge exit loads for redemptions within 1 week or month from the investment date. Overnight and liquid funds offer the highest liquidity to investors but if you have investment tenures of 3 – 6 months or longer then arbitrage funds also offer fairly high liquidity.

Taxation: Arbitrage funds are much more tax efficient than overnight, liquid and ultra-short duration funds. Capital gains in debt funds (like overnight, liquid and ultra-short duration) held for less than 3 years are taxed as per the income tax rate of the investor. On the other hand, capital gains in arbitrage funds held for less than a year are taxed at 15%. If your arbitrage fund investment is held for more than a year, then profits of up to Rs 1 lakh in a financial year are tax exempt; profits exceeding Rs 1 lakh will be taxed at 10%.

Returns: The one year trailing returns of overnight, arbitrage, liquid and ultra-short duration funds are 5.8%, 6%, 6.7% and 7.6% respectively. Arbitrage funds outperformed overnight funds. Even though arbitrage funds underperformed liquid funds on a pre-tax basis, it would have outperformed slightly on a post-tax basis for investors in the highest (30%) tax bracket even for investments held for less than a year. For investment tenures of more than a year, arbitrage funds would have clearly outperformed by a substantial margin for investors in the highest tax bracket. Your tax situation should be an important consideration when making investment decisions.

Arbitrage Funds apt for…

• Investors with a low risk profile who not only want to have high gains from a high volatile market but also want to take calculated risks

• Investors looking to invest for short to medium duration

It is an added advantage that most of the funds may give negative returns or get unpredictable in a highly unstable market, whereas this mutual fund is the only low risk security that flourishes in a volatile market. Here, gains and volatility go together.

On the flip side…

On the other hand, it is also the drawback of this fund that it under performs in a stable market.

Cost is an important factor that arbitrage fund investors need to take into consideration. Such funds charge an annual fee - referred to as expense ratio - in the form of percentage of the fund's assets. The fee is inclusive of the fund manager fees as well as management charges. As a result of frequent trading, arbitrage funds attract higher expenses and have a high turnover ratio. In addition to all this, the fund charges an exit load, which can further hamper the returns.

Arbitrage funds gain traction

Arbitrage funds, which leverage price differential in cash and derivatives market, to generate returns are gaining traction among high net worth investors in recent times. There is a flight to safety among some investors from debt funds which have been in the news due to credit events. Arbitrage funds as a category seem to be continuing to attract investor attention probably on account of their relatively stable returns and tax efficiency. Investors in the higher tax bracket make better post-tax returns in arbitrage versus liquid funds. Equity funds pay dividend distribution tax of 11.64% (including surcharge and cess) while liquid funds pay 29.12% DDT (including surcharge and cess). This puts arbitrage funds in an advantageous position. Also, the short-term capital gains tax in arbitrage funds is 15% while investors in the higher tax category have to shell out 30% tax in liquid funds. The markets have been volatile which has provided a good opportunity for this category. Moreover, the awareness about this category has increased.

The returns of the investors may get moderated due to the higher transaction costs, higher trading volume and other fund expenses. The fund managers must explore and spot arbitrage opportunities regularly to generate consistent returns for the investors. Further, in the periods with fewer arbitrage opportunities, the fund manager may also deploy the funds in fixed income securities, while maintaining the minimum equity exposure of 65% as required by the Securities and Exchange Board of India (SEBI) regulation. Such funds have generated an average return of 5.93% over the last year and even better CAGR returns of 7.06% over a10-year period. Considering the risk-free nature of the investment, such returns may be deemed reasonable, as against the prevailing savings bank rates.

Arbitrage funds on a reversal trend now…

Assets under management (AUM) of arbitrage funds have surged about 67 per cent from Rs. 52,062 crore in March 2019 to over Rs. 87,000 crore in March 2020. This category that carries very low risk in ordinary circumstances witnessed volatility and large outflows of nearly Rs 32,000 crore in March 2020. The primary reason for the pull-out of funds from this segment was that stock prices in the futures segment went into a discount, compared to the cash segment. Normally, the former trades at a premium. Arbitrage spreads are normally available in the 35-40 bps range, but have currently narrowed to 15-20 bps with many securities trading at discount. Fund houses like Tata and ICICI Mutual Fund are suspending fresh flows to arbitrage schemes on thinning spreads. However, Edelweiss Mutual Fund took a contrary view. They have always believed in arbitrage funds as a great category for medium term investments. This has proved true as spreads came back to good levels very quickly. Now people are concerned about their own income and cash flows amid the lockdown. Therefore, people who are in industries which are directly impacted by the Coronavirus outbreak such as travel and tourism etc. may stop their SIPs going forward or may have already done.

The ultimate winner – prudent investing and financial discipline

In an endeavour to achieve higher returns on their investments with less risk involved, investors are constantly in search of different investment options. Initially, investors (especially the risk-averse ones) put their money in debt instruments until the mayhem of corporations defaulting to repay happened. Equity markets are the foremost to undergo extreme highs and lows. And investing in pure equity is not suitable for the fainthearted. In this scenario, even aggressive investors are being extra cautious. And the current volatile environment opens a tiny door of opportunity to exploit the price differences between two markets to generate returns. The mutual fund industry has a separate product category to tap such "mispricing" opportunities -arbitrage funds. However, make sure you have a clear objective in mind, know your financial goals, risk profile, and the time horizon before you invest your hard-earned money. Accordingly, you need to invest based on your personalised asset allocation. Prudent investing and financial discipline are vital measures for long-term financial well-being.