FUND FULCRUM

April 2021

Year 2021 started on a positive note for the mutual fund industry. In line with the equity markets rally, the total AUM of the mutual fund industry has reached Rs.31.84 lakh crore in January 2021 from Rs.30.96 lakh crore in December 2020, a growth of 3%. However, equity funds continue to witness outflows for the seventh consecutive month with a net outflow of Rs. 9,253 crores in January 2021. January 2021 saw measured maturity-driven redemptions led by smart, goal-based investing and the desire to book profits with equity indices reaching an all-time high. Inflows continued through the SIP route, as seen from rising number of new SIP registrations coupled with robust monthly SIP contribution. On the debt side, owing to regulatory measures to ease liquidity, and also the stance to hold on to the policy rates, some of the debt categories like corporate bond fund, banking & PSU fund, short duration funds have seen positive flows. Even the credit risk funds are now moving into positive flows, given that the risk-return dynamics is working in favour of retail investors. All this has resulted in the mutual fund industry AAUMs breaching all time high at Rs.31.84 lakh crore.

Overall, equity schemes have witnessed net outflows of Rs 9,253 crore in January 2021. However, net outflows have reduced from Rs 10,147 crore in December 2020. All equity funds except sectoral/thematic and dividend yield funds have registered net outflows due to profit booking. Flexi cap funds saw highest net outflows of Rs 5,933 crore followed by multi cap fund with net outflows of Rs 2,857 crore. Large cap funds have witnessed net outflows of Rs 2,853 crore. Mid and small cap funds have seen net outflows of Rs 1,206 crore and Rs 1,572 crore respectively. Number of folios in equity funds has risen by 6.69 lakh to 6.44 crore in January 2021. Debt funds have witnessed net outflows of Rs 33,408 crore led by huge outflows in liquid funds of Rs 45,315 crore followed by low duration funds with net outflows of Rs 8,000 crore. The industry has also recorded net outflows in money market funds, medium to long duration funds, long duration funds and gilt funds. On the other hand, short duration funds, corporate bond fund, floater funds and medium duration funds and banking and PSU funds have seen net inflows. Hybrid funds have witnessed net inflows led by arbitrage funds with net inflows of Rs 5,234 crore. Balanced advantage fund and conservative hybrid fund have also witnessed net inflows. On the other hand, aggressive hybrid fund, multi asset allocation fund and equity savings fund have recorded net outflows. SIP inflows have witnessed a marginal decline as SIP inflows decreased to Rs 8,023 crore in January 2021 from Rs 8,418 crore in December 2020. In addition, SIP folios grew to 3.56 crore in January 2021 from 3.47 crore in December 2020. Overall, SIP AUM has declined to Rs.3.90 lakh crore in January 2021 from Rs. 3.98 lakh crore in December 2020. Overall, the mutual fund industry has witnessed net outflow of over Rs 35,586 crore.

 

SBI, Axis, Kotak, Edelweiss and Mirae Asset have emerged as the top five fund houses to log the highest growth in assets during 2020. SBI MF topped the table as its AAUM rose by 29% or Rs 1.03 lakh crore during 2020. It was largely because of the contribution from actively managed equity funds along with the consistent inflows to ETFs where Employees' Provident Fund Organisation (EPFO) is a major contributor. Next in the list is Axis MF with 44% or Rs 54,606 crore rise in its AUM over the last year. Kotak MF, Edelweiss MF and Mirae Asset MF follow in the list at 3rd, 4th and 5th spots respectively. Kotak MF witnessed Rs 39,267 crore increase in AAUM, Edelweiss MF Rs 29,009 crore and Mirae Asset MF Rs 18,721 crore. Asset growth of Kotak MF and Mirae Asset MF was also driven by inflows to their equity funds and their performance, while Edelweiss saw considerable inflows to the Bharat Bonds ETF. In percentage terms, ITI MF witnessed the highest growth in AAUM at 396% followed by Edelweiss MF at 234% and PPFAS MF at 139%. SBI MF, HDFC MF and ICICI Prudential MF are the top three fund houses in terms of AUM. Overall, 27 fund houses witnessed an increase in the assets during 2020 while 14 fund houses saw a decline in their AAUM. 

 

The data released by AMFI shows that direct plan in equity funds account for 19% of the industry assets while direct plans in debt funds and liquid/money market funds constitute 57% and 76% of the total assets respectively. The proportion of direct plan in the total equity AUM will go up in future considering the growing awareness of mutual funds in India. However, majority of retail investors still prefer MFDs (Mutual Fund distributors)/advisors to invest in equity funds as they find it difficult to select funds, review portfolio and evaluate risk. Overall, the proportion of direct versus regular AUM in the mutual fund industry stands at 47:53 as on November, 2020. This is due to the higher participation of institutional investors in debt funds through direct plans. AMFI data shows that individual investors continue to invest in regular plans with the help of MFDs. While 15% of the retail assets is direct, 24% of HNI assets is direct.

 

The AUM of SIPs crossed the Rs 4 lakh-crore mark for the first time in February 2021. According to data released by AMFI, the SIP AUM stood at Rs 4.21 lakh crore at the end of February 2021. The figure is 7.97% higher than the January-end AUM of Rs 3.9 lakh crore. The increase was mainly due to a surge in value of underlying assets of mutual funds. The SIP inflow contribution recorded in February 2021 is just Rs 7,528 crore as against a Rs 31,128 crore rise in SIP AUM. At Rs 7,528 crore, SIP inflow contribution in February 2021 was lower than that recorded in the previous month. It was Rs 8,023 crore in January 2021. Of the total monthly contribution, Rs 6,163 crore was under 'Regular' plan and Rs 1,365 crore under 'Direct' plan. Total number of outstanding SIP accounts rose to 3.63 crore in February 2021. It was 3.55 crore at the end of January 2021. Almost 15 lakh new SIPs were registered last month. Over 7.8 lakh accounts either completed their tenure or were discontinued/paused. Scheme-wise data shows that around 85% SIP accounts are in equity-oriented schemes. Out of the total 3.63 crore accounts, about 3.07 crore accounts are in these schemes. Growth in SIP AUM was seen across all categories of schemes except liquid and overnight funds. The AUM of these funds declined by 0.8% to Rs 277.33 crore. For equity oriented schemes, AUM went up 8% to Rs 3.7 lakh crore.

 

According to the monthly numbers released by Association of Mutual Funds in India (AMFI), investors sold equity mutual funds worth Rs 4,534 crore in month ended February 28, 2021. For the previous month, the number stood at Rs 9, 253 crores. Among equity funds, flexi cap funds lost Rs 4,497 crore in February 2021 compared to net redemptions of Rs 5,933 crore in January 2021. This category saw the highest redemptions across equity fund categories. Equity linked savings schemes (ELSS) – popularly known as tax saving funds saw net redemptions of Rs 847 crore as compared to Rs 820 crore in previous months. Systematic investment plans, which are used by many individual investors as preferred means of investments in mutual fund schemes continue to see inflows. However, the contribution dipped to Rs 7,528 crore in February 2021 as compared to Rs 8023 crore in January 2021. Number of SIP accounts outstanding stood at 3.62 crore in February 2021 as compared to 3.54 crore in January 2021. Balanced advantage funds saw net investments of Rs 2005 crore compared to Rs 658 crore in January 2021. This along with other categories, ensured that the hybrid funds which invest in varying mix of equity, debt and gold saw inflows of Rs 4702 crore in February 2021 compared to 2141 crore in January 2021. Bond schemes have seen net inflows of Rs 1,734 crore. Short duration funds and corporate bond funds saw net redemptions of Rs 10,286 crore and Rs 6,751 crore respectively, in February 2021. In the previous months, these categories saw net inflows of Rs 6,892 crore and Rs 5,428 crore, respectively. The redemptions in bond funds are attributed to the rising yields. Rising bond yields lead to fall in bond prices and also pulls down net asset values of bond funds. Gold ETFs continue to see net investments in February 2021, though at a slower pace. Investors invested Rs 491 crore compared to Rs 624 crore in January 2021. Total assets under management for the mutual fund industry stood at Rs 32.29 lakh crore as on February 28, 2021, compared to Rs 31.84 lakh crore as on January 31, 2021.

Piquant Parade

Sundaram Mutual Fund has announced acquisition of Principal Mutual Fund. With this, Sundaram will acquire the schemes managed by Principal Mutual Fund and acquire 100% of the share capital of Principal AMC and Principal Retirement Advisors. The transaction is subject to regulatory approvals. Till then, Principal MF will continue to operate the businesses. Currently, Sundaram MF manages assets of over Rs. 40,000 crores, the majority of which is in equity oriented schemes. Principal MF has AUM of Rs. 7,447 crores as on December 31, 2020 with about 90% of this in equity-oriented schemes. With this, Sundaram Mutual Fund will become the 15th largest AMC in the industry by overtaking Edelweiss AMC and Invesco AMC. This transaction will strengthen their presence in the marketplace with the addition of a range of schemes with a good long term performance track record across the large and mid-cap segments. This will complement their business which has traditionally been weighted towards the mid- and small-cap segment. They will benefit from Sundaram Asset Management’s larger mutual fund platform in this market.

Nippon India Mutual Fund has entered into an agreement with Taiwan based asset manager Cathay Site to use their expertise to explore areas for developing, managing, marketing and distributing each other’s products in their respective markets. Both companies will seek to develop and explore business opportunities in active and passive strategies and leveraging upon their distribution reach in India and Taiwan. Cathay’s reach and breadth of product offerings will enable Indian investors to have much needed diversification out of their local market by providing access to a sophisticated, technology heavy market. This exclusive partnership would enable Indian investors to partake of a unique high technology, high growth market and diversify the basket of products available, which they can choose from in accordance with their investment appetite. Cathay SITE manages AUM of $26.76 billion. 

 

Franklin Templeton Mutual Fund has said that its six shut schemes have received Rs 15,272 crore from maturities, coupons and pre-payments since closing down in April 2020. The fund house had shut six debt mutual fund schemes on April 23 2020, citing redemption pressures and lack of liquidity in the bond market. The six schemes are Franklin India Low Duration Fund, Franklin India Dynamic Accrual Fund, Franklin India Credit Risk Fund, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond Fund and Franklin India Income Opportunities Fund. The court-appointed liquidator, SBI Funds Management, is in the process of preparing to liquidate the schemes and distribute proceeds to unitholders at the earliest opportunity. SBI Funds Management, with support from Franklin Templeton, has finalised the standard operating procedure (SOP) to monetise assets of the schemes under winding up and distribute the proceeds and has filed the SOP with the Supreme Court. It anticipates that SBI Funds Management will commence active monetisation very shortly. The fund house said that cash available for distribution in the five cash positive schemes stands at Rs 1,370 crore as of March 15, 2021.

Regulatory Rigmarole

SEBI has clarified that the revised fee structure for registration and renewal of RIA license is applicable from the next financial year 2021-22. In a recent corrigendum to its earlier notification on RIA regulations, SEBI has clarified that the reduced fee structure for registration and renewal of RIA license will be applicable from April 1, 2021. On January 11, SEBI announced the reduction of the registration fee required for RIA license to Rs.3000 and Rs.5000 for individuals and corporates, respectively. With this, individuals and firms (partnership) will have to pay Rs. 3,000 to obtain a new license and Rs. 1,000 to renew existing license as against Rs 10,000. For corporates including limited liability partnerships (LLPs), the registration fee is reduced to Rs 15,000 from Rs 5 lakh. Renewal fees have also come down to Rs 5,000 from Rs 5 lakh. Moreover, applicants who want to know the status of RIA application will have to pay Rs 2,000 (individuals) and Rs 10,000 (corporates). The fee for such a request earlier was Rs 5,000 for individuals and Rs 25,000 for corporates.

SEBI has allowed the MF industry to set up Limited Purpose Clearing Corporation (LPCC) based on recommendation of a working group set up by the Mutual Fund Advisory Committee (MFAC). The working group had members from fund houses, AMFI and Clearing Corporation of India. SEBI said that LPCC would clear and settle repo transactions in corporate debt securities. Industry experts believe that LPCC will help fund houses deal with redemption pressure and settle transaction in corporate bond markets. LPCC will have corpus of Rs.150 crores. Each fund house will have to contribute to this corpus in proportion to their debt assets. Barring liquid and overnight funds, investors will get NAV once the money reaches the fund house irrespective of the investment amount. So far, investors get same day NAV if they invest up to Rs.2 lakhs before the cut off time. Now, NAV allocation will largely depend on efficiency of the financial system.

SEBI has issued a consultation paper to introduce the concept of accredited investors in India. Accredited investors are sophisticated investors with acumen to understand risk associated with financial products. These investors have a higher financial capacity and a greater ability to absorb loss. They can request manufacturers like asset management companies to customize their offerings based on their specific needs. With this, the market regulator aims to provide a relaxed regulatory framework for sophisticated investors and introduce products designed to meet investor-specific risk profile. Among some key benefits of becoming accredited investors are access to customized products and no barriers on entry such as minimum investment size (for instance, these investors can invest less than Rs.50 lakhs in PMS and Rs.1 crore in AIFs). Entering into an arrangement with product manufacturers with specific terms and conditions, reduced compliance costs, less marketing cost, flexibility in designing products and ease of launching innovative products are the benefits to AMCs. Individuals, HUFs and family trusts can become accredited investors if they fulfil any of these three criteria - annual income of at least Rs 2 crore, networth of at least Rs.7.50 crore with minimum of Rs.3.75 crore of financial assets. annual income of at least 1 crore and networth of at least Rs.5 crores with at least Rs.2.50 crore in financial assets. The validity of accredited investor is proposed to be 1 year. In addition, it is believed that investors will have to apply with SEBI to become accredited investors. 

SEBI has asked AMCs to disclose the fund's return in Rupee terms along with CAGR. With this, AMCs will have to disclose returns in absolute terms. Dividends have to be disclosed in Rupee terms. On maturity of close end funds, fund houses will have to advertise about entire distributable dividends. Overnight funds, liquid funds and money market funds will have to disclose returns of 7 days, 15 days and 30 days. Fund houses cannot advertise performance if the fund has not completed six months. Inception date will be date of issuance of mutual fund units and not the date of launch of scheme. Fund houses will have to update SID on half yearly basis.

SEBI issues additional guidelines on voting to ensure MFs use voting rights in best interest of the unitholders. SEBI made it mandatory for mutual funds to exercise voting rights attached to securities held by the funds. The market regulator also issued additional guidelines to ensure mutual funds use voting rights in the best interest of the unitholders. The regulation will come into force on April 1, 2021. The rule applies to all mutual funds including passive funds - index funds and ETFs. Mutual funds are exempted from casting their votes if they do not have any economic interest on the day of voting. Vote has to be cast at the fund house level. In case a fund manager strongly disagrees with managers of other schemes within the fund house, voting at scheme level can also be done. Fund managers have to submit a declaration on quarterly basis to the trustees that the votes cast by them were in the best interest of the unit holders. Trustees have to submit half yearly report to SEBI.

The market regulator has put a cap on exposure to debt instruments having special features like convertible bonds and perpetual bonds. With this, SEBI has put 10% cap on exposure to bonds having special features like convertible bonds, Tier I and Tier 2 bonds. These bonds have special features such as subordination to equity and convertible to equity upon trigger of a pre-specified event for loss absorption, according to SEBI. Currently, there is no limit on exposure to such instruments. Mutual Funds can invest up to 10% of the total scheme corpus in such bonds. They cannot invest more than 5% of the total scheme corpus in such bonds issued by single issuer. At AMC level, they can have total exposure of 10% to such bonds from single issuers. Existing funds will have to reset their scheme to comply with the new norms. However, these funds can hold such securities until maturity. Fund houses will have to incorporate changes in SID if they wish to create segregated portfolio with such securities in future. Fund houses can consider 100 years to calculate valuation of perpetual bonds. The rule came into effect from April 1, 2021.

Trustees, in their half yearly reports, will now have to inform SEBI if their AMC fails to comply with any of the norms prescribed for mutual funds, according to the new reporting norms issued by the regulator. The corrective steps taken by the AMC will also be a part of the report. Trustees will have to submit the half-yearly report within two months from the end of each half year. SEBI has issued changes to other reporting formats as well. AMCs no longer need to submit compliance certificate to trustees on a bi-monthly and half-yearly basis, according to the new guidelines. Since AMCs have been sharing this on quarterly basis, the market regulator has relaxed frequency of such reporting. The new format for quarterly reporting requires AMCs to share details like the number of live schemes, schemes launched during the period including schemes which were launched but could not be constituted for any reason, schemes rolled-over during the quarter, among others. For wound-up schemes, AMCs will have to share details of payout in the quarterly report. These reports will have to be submitted to trustees within 21 days from the end of each quarter. The guidelines for reporting by AMCs to SEBI has been modified as well. Instead of exceptional reporting, AMCs will now have to submit complete compliance certificate test (CTR) to the regulator on a quarterly basis. This submission has to be made by 21st of the succeeding month after the end of a quarter.

 

 Interestingly, 84% of the MFDs feel that active fund managers will continue to beat their benchmark indices and 83% of the MFDs were confident of their ability to pick the winners for their clients. While 43% of MFDs believe that mutual fund industry will reach AUM of Rs.50 lakh crore (i.e. almost double the size in August) by 2025, another 40% feel that the mutual fund industry will become a Rs.75 lakh crore (i.e. almost triple the size in August) industry. Similarly, as many as 26% of the MFDs were confident that their mutual fund business would grow 5 times or more in the next 5 years while 43% of MFDs said that it will double in the next 5 years. 26% said their business would be at the same level and balance 5% were looking to exit the business in the next 5 years. Poor perception, low awareness, and complexity of mutual funds are constraining the growth of the mutual fund industry. However, the silver lining is that once they invest, investors have a positive experience with mutual funds - only 22% of MFDs feel that many investors have had a poor past experience with mutual funds. While the Mutual Funds Sahi Hai campaign has worked for the industry, (these scores are much better than those in our previous studies done 2 and 4 years back), there is still a lot of ground to be covered if the industry has to reach its true potential and reach every household in the country.

 

NFONEST

April 2021

Three NFOs, one liquid fund and two fund of funds are open at present and find a place in the April 2021 GEMGAZE.   

Trust Liquid Fund

Opens: April 8, 2021

Closes: April 22, 2021

Trust Mutual Fund has launched a Trust Liquid Fund, an open-ended liquid fund predominantly investing in debt and money market instruments. The objective of the scheme is to provide reasonable returns at a high level of safety and liquidity through investments in high quality debt and money market instruments. The fund will follow a structured investment approach backed by ‘Limited ACTIV’ methodology, with the objective of delivering consistent risk-adjusted returns. The robust methodology has been developed in collaboration with CRISIL. The scheme’s performance will be benchmarked against CRISIL Liquid Fund Index. It will be managed by Mr Anand Nevatia.

BNP Paribas Funds Aqua Fund of Funds

Opens: April 16, 2021

Closes: April 30, 2021

BNP Paribas Mutual Funds has launched its new fund offer – BNP Paribas Funds Aqua Fund of Funds, an open ended mutual fund of funds scheme. The primary investment objective of the scheme is to seek capital appreciation by investing predominantly in units of BNP Paribas Funds Aqua (Lux). The scheme’s performance will be benchmarked against MSCI World Index Total Return Index. It will be managed by Mr. Abhijeet Dey and Mr. Karthikraj Lakshmanan.

HDFC Asset Allocator Fund of Funds

Opens: April 16, 2021

Closes: April 30, 2021

HDFC Asset Allocator Fund of Funds is an open ended Fund of Funds scheme with the investment objective of investing in equity oriented, debt oriented and gold ETF schemes. The fund is benchmarked against – 90% NIFTY 50 Hybrid Composite Debt 65:35 Index (Total Returns Index) and 10% Domestic Prices of Gold arrived at based on London Bullion Market Association's (LBMA) AM fixing price. The fund managers are Mr. Amit Ganatra, Mr. Anil Bamboli and Mr. Krishan Kumar Daga.

Invesco India Medium Duration Fund, ICICI Prudential FMCG ETF, ICICI Prudential Consumption ETF, Kotak Nifty 50 Index Fund, DSP Nifty 50 ETF, UTI Multi Cap Fund, ICICI Prudential Small Cap Index Fund, ICICI Prudential NASDAQ 100 Index Fund and ICICI Prudential EDGE FOF are expected to be launched in the coming months.

 

GEMGAZE

April 2021

Three GEMs from the 2019 GEMGAZE have performed reasonably well through thick and thin and figure prominently in the 2021 GEMGAZE too. JM Arbitrage Fund and SBI Arbitrage Opportunities Fund have been shown the exit door by virtue of their lacklustre performance and Edelweiss Arbitrage Fund and Nippon India Arbitrage Fund have been accorded a red carpet welcome.

Kotak Equity Arbitrage Fund Gem

Incorporated in September 2005, Kotak Equity Arbitrage Fund has an AUM of Rs 16,362 crore. The fund is a blend of value and growth style of investing with an objective to generate income through arbitrage opportunities emerging out of pricing anomaly between the spot and futures market, and also through the deployment of surplus cash in fixed income instruments. The fund has given annualized return of 7.11% since inception. The one-year return of the fund is 3.64% (4.22% for the direct plan) modestly ahead of the category average of 2.93% (3.58%). Top five holdings constitute 32.81% of the portfolio. The portfolio turnover ratio is 457.78% and the expense ratio is 1 % (0.41% for the direct plan). The fund is benchmarked against the Nifty Fifty Arbitrage Total Return Index with Mr. Hiten Shah efficiently managing the fund since October 2019.

Edelweiss Arbitrage Fund Gem

The Rs 3393 crore Edelweiss Arbitrage Fund, incorporated in June 2014, has earned a one-year return of 3.45% (4.19% for the direct plan) trailing the category average return of 2.94% (3.58% for the direct plan). Top five holdings constitute 17.39% of the portfolio. The portfolio turnover ratio is 357% and the expense ratio is 1.09%. The fund is benchmarked against the NIFTY 50 Arbitrage Total Return Index. The fund is managed by Bhavesh Jain since June 2014 and Dhawal Dalal since December 2016.

Nippon India Arbitrage Fund Gem

Nippon India Arbitrage Fund, incorporated in October 2010, has an AUM of Rs 9,936 crore. Its one-year return is 3.58% (4.3% for direct plan), as against the category average return of 2.94% (3.58% for direct plan). The top five holdings constitute 23.75% of the portfolio. The portfolio turnover ratio of the fund is a massive 1298%. The expense ratio is comparatively low at 1.01% (0.34% for direct plan). The fund is benchmarked against the NIFTY 50 Arbitrage Total Return Index. The fund is managed by Anand Devendra Gupta since September 2018 and Anju Chhajer since February 2020.

IDFC Arbitrage Fund Gem

IDFC Arbitrage Fund is a fourteen-year old fund with an AUM of Rs 6,756 crore. The fund was launched in December 2006, and has given 6.76% since its launch. Its one-year return of 3.27% (4.03% for direct plan) is a tad higher than its category average of 2.94% (3.58% for direct plan) at present. Top five holdings constitute 21.31% of the portfolio. While the portfolio turnover ratio is high at 253%, the expense ratio is very low at 0.97% (0.37% for direct plan), an icing on the cake, indeed. The fund has been managed by Yogik Pitti since June 2013, Harshal Joshi since October 2016, and Arpit Kapoor since March 2017.

ICICI Prudential Equity Arbitrage Fund Gem

Incorporated in December 2006, ICICI Prudential Equity Arbitrage Fund has an AUM of Rs 10,456 crore. The fund has performed consistently over a long period of time and has given annualized return of 7.15% since inception. The one-year return of the fund is 3.4% (3.94% for direct plans) slightly ahead of the category average of 2.94% (3.58% for direct plans). Top five holdings constitute 18.52% of the portfolio. The portfolio turnover ratio is 188% and the expense ratio is 0.98% (0.45% for direct plan). The fund is benchmarked against the Nifty Fifty Arbitrage Fund Total Return Index with Mr. Kayzad Eghlim, Mr. Nikhil Kabra and Mr Rohan Maru.  efficiently managing the fund since February 2011, December 2020 and December 2020 respectively.

 

FUND FLAVOUR

April 2021

Arbitrage Funds

Arbitrage funds work on the mispricing of equity shares in the spot and futures market. They take advantage of the price differences between current and future securities to generate maximum returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets.

Reasonable returns…

Return on arbitrage funds primarily stem from arbitrage opportunities, interest on deposits kept as margin collateral and interest on the remaining debt and liquid component. Margin money required for taking arbitrage position (i.e. future positions) in the market is, generally, kept in the form of short-term deposits, cash or cash equivalents in accordance with the regulations. Funds have to maintain enough balance to maintain that account on a daily basis. At the end of each trading day, the margin account is adjusted to reflect gain or loss depending upon the future closing price. Arbitrage opportunity is based on the spread, open interest and the margin needed for the position. The spread is the difference in the cost price and the selling price of securities. Open interest is the derivative positions that are not closed. Open interest provides a big picture of the trading activity in the market and whether there is increased or decreased participation. Usually, higher open interest enhances the chances of a healthy spread. The job of a fund manager is to identify the pockets of arbitrage opportunities from which to gain. Identifying opportunities may also mean identifying market-cap segments (large, mid) where the volatility is more. But the fund manager needs to balance that with the margins needed for such stocks. The fund manager may also rollover positions, i.e., carry forward the current futures position to the next series. In this process too, the fund manager may generate reasonable returns. Arbitrage funds need to invest at least 65% of the portfolio in equities and equity-related instruments so as to remain as an equity fund under tax laws and qualify for lower taxation rates, 10 to 25% in fixed deposits (for margin money) and 0 to 10% in debt and money market instruments (mainly TREPS). 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 such 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.

 …with insignificant risk

 By their very nature, the portfolio of Arbitrage funds tends to carry hedged exposures. In simple terms, long exposures for security will be covered with a short position in the futures segment or at another exchange. By virtue of the investors not carrying open exposures for equity securities, investors are exposed to insignificant quantum of investment risk. The fund manager will ensure that the investments are made only in high-credit quality debt securities such as zero-coupon bonds, debentures and term deposits. This helps in keeping the fund returns in line with the expectations during the period of inadequate arbitrage opportunities. Apart from being an excellent investment option when the market is unstable, these funds historically are known to generate higher returns (approximately 8%), which is much higher than the traditional investment options like fixed deposits and savings bank accounts. Not to mention, arbitrage fund taxation is another reason why it is popular among investors. In a nutshell, arbitrage funds leverage market inefficiencies with an aim to reap benefits for investors.

Arbitrage Funds shine despite the hiccup

The calendar year 2020 was not reassuring for arbitrage funds.  A majority of them witnessed negative returns in May 2020, their worst monthly performance in 2020. In April and May 2020, the market sentiment was negative due to COVID-19. The one-year category returns—average returns of all arbitrage funds—fell to 3.6% as of January 1, 2021, according to data from Value Research. In the past three, five and ten years, these funds had an annualized return of 5.1%, 5.6% and 7.16%, respectively. Considering the risk-free nature of the investment, such returns may be deemed reasonable, as against the prevailing savings bank rate. In addition, they make sense for some investors depending on their tax bracket and investment horizon.

Safety under the scanner?

Arbitrage fund returns at times can be volatile or they can post a negative return on a single day due to mark to market (MTM) losses. This MTM loss can happen in both equity and debt portions. The mark to market valuation of equity portion of the portfolio happens daily till the expiry date. This valuation is benchmarked against the locked-in yield / rollover yield of the portfolio which in turn decides the return for the day. So, even if the market has gone up or down on a single day, the portfolio movement can be opposite till the existing positions are closed and new rollover yield is locked-in from the previous level of locked in yield of the portfolio. There can be volatility or negative returns due to debt portions as well because of MTM and higher duration paper. The above scenarios can drive arbitrage fund to post a negative return. However, one single day return can be an outlier and may not be worthwhile to measure fund’s consistency over a period of time.

Arbitrage funds are relatively safe, and carry little risk. The risk of equities is reduced by hedging against derivatives. However, there are certain inherent risks attached to arbitrage strategies and factors like lack of arbitrage opportunities, their perfect execution and the liquidity in the stock/cash and futures segments can contribute to the uncertainty and risk. If you invest in low rated debt instruments, there are some risks like default risk and rating downgrade risks.

Arbitrage funds make profits from low-risk buy-and-sell opportunities in the cash and futures market. Their risk level is comparable with that of a pure debt fund. Several arbitrage funds follow CRISIL BSE 0.23% Liquid Fund Index as their benchmark. These funds are apt for those investors who are looking to have equity exposure but are worried about the risk associated with the same. Arbitrage funds are a safe option for risk-averse individuals to safely park their surplus funds when there is a persistent volatility in the market.  

Preferred fund parking spaces…

Arbitrage funds as a category saw strong growth in the previous financial year, as investors sought pockets of safety with credit risks taking a toll on debt schemes. Since the beginning of the last financial year, the asset base of arbitrage schemes has risen about 71 per cent — from Rs 50,839 crore to around Rs. 87,000 crore in February.

The bottomline…

If you redeem your investments in an arbitrage fund for up to one year, the profits will be taxed as short-term capital gains (STCG). The tax treatment of arbitrage funds is the same as any other equity fund. You will pay a tax of 15% on STCG. In the case of liquid funds (or debt schemes), profits are taxed as STCG for up to three years. If you withdraw before three years, your gains are clubbed with your income and tax is payable at the marginal rate. If you are in the 20% or 30% tax bracket, and if returns from liquid and arbitrage funds are the same, your post-tax returns would be higher in the arbitrage funds if you withdraw within three years of investing. If you redeem after one year, there is no tax for profits up to Rs.1 lakh. Any gains over that are taxed at 10%. If you are in the highest tax bracket, in specific circumstances, it may still make sense to invest in arbitrage funds. Their one-year returns are on par with that of liquid mutual funds. If you are investing in an arbitrage fund, keep a minimum six-month horizon, and do not worry about short periods of negative returns. The way the product is structured, they do not give negative returns if you hold them for over six months. In certain market conditions, arbitrage opportunities are limited. If you ride it out, you can still make better post-tax returns in arbitrage funds over short-term debt funds.

Advance tax payment obligations, deterioration in asset quality, potential risk of defaults in the COVID -19 lockdown and heightened volatility in the Indian debt market are some of the key reasons for outflows from debt-oriented mutual fund schemes. Unprecedented redemptions in the Arbitrage Funds and Liquid Funds, as well as the net inflows recorded by the overnight funds, suggest that investors preferred safety over returns. Liquidity is a key concern as the world continues to fight the COVID-19 pandemic. If you have an extreme short-term time horizon (of 3 to 6 months), consider a Liquid Fund with high-quality debt papers, which does not have high exposure to Commercial Papers (issued by private entities). Alternatively, if you wish to park in a much safer category, you would be better off investing in Overnight Funds. To park money for the short-term for an investment time horizon up to 1 year, you may consider investing in an Arbitrage Fund.