FUND FLAVOUR
March 2010

Versatility in volatility…

Arbitrage Funds are versatile - ideal investment vehicles for those who want debt exposure, to get the tax-break of an equity investment, and to skip the volatility of the equity market. From the point of view of taxation, equity is the most efficient asset class. The dividend income from the equity and long-term capital gains are both tax-free. From the point of view of investment, equities are volatile in nature. Arbitrage funds circumvent volatility by acting like debt funds, but their tax treatment is that of equity diversified funds. Arbitrage funds take advantage of the mispricing between the cash and the derivatives market by going long in the cash market and short in the futures market. In this way, the fund manager hedges the risk. Hence, regardless of market movements, the returns on equity should always be in the green. In a nutshell, while arbitrage funds are classified as equity funds giving you the tax benefit, they do have an exposure to debt and their equity holdings are also hedged. Hence, the volatility associated with equity is conspicuous by its absence.

Risk-free?

There is a popular belief that arbitrage funds are risk-free. But this is a myth… If earning irrespective of the market fluctuations without having to bear any unwarranted risks was so easy, then all of us would have been millionaires. The fact that arbitrage funds rely heavily on the limited number of arbitrage opportunities, authorization in the case of certain funds to go for stocks in case there are no lucrative arbitrage chances, non-convergence in the price of the stock in the cash and futures segments when the futures contract expires, and lack of liquidity (a fund manager may not be able to buy the required number of shares at a predetermined price) can make this strategy highly risky.

Reasonable returns in recession…

You cannot expect mind boggling returns from arbitrage funds. Such funds, by nature, resort to heavy trading resulting in lower arbitrage margins and higher expense ratios. In the stock market debacle of 2008, these funds turned in 8.52 per cent. You may consider this fabulous or mediocre, depending on what you compare this with. If you compare it with equity diversified funds (category average of -55.08 per cent), it stands tall. If you compare it with income funds (category average of 14.30 per cent), it is disappointing.

…augmented the AUM

The average AUM of the arbitrage funds category in February, 2010 stood at Rs 5700 crore, which is a 400 per cent increase from a paltry Rs 1100 crore in July 2008. Kotak Equity Arbitrage fund at Rs 785 crore is the largest arbitrage fund in terms of AUM, with Benchmark Derivative being the smallest at Rs 33 crore. In view of the small size of the futures segment, an increase in the amount of money to be managed, will force arbitrage funds to invest in debt funds which generate lower returns. While some fund houses chose not to accept fresh applications, HDFC, Religare, SBI, Benchmark, IDFC, and JP Morgan accepted fresh applications. Interestingly, Birla Sun Life Mutual Fund launched an arbitrage fund, ‘Birla Sun Life Enhanced Arbitrage Fund’ in June 2009.

Returns rally…

The arbitrage funds have proven to be consistent performers over a period of time. The arbitrage funds gave a return of around 8 per cent even when most other equity funds saw their net asset values (NAVs) falling by over 50 per cent. For arbitrage funds, stock prices are not significant but volumes in futures are of much more importance. In 2008-09, volumes in future trading were about Rs 85,000 core per day and now they have come down to about Rs 15,000 crore per day. For better returns in arbitrage funds, both volatility and volumes are required as they create more investment opportunities. Arbitrage funds gave a positive return of 0.37 per cent for September 2009 and to 0.5 per cent in October 2009. Overall, till the end of October 2009, arbitrage funds gave a return of 4.15 per cent, while their one-year return was 5.71 per cent. The best fund over a one-year period, ending November 2009, is UTI SPrEAD-G with a 7.90 per cent return, while the worst is Benchmark Derivative-G with a 4.15 per cent return. The category average is 5.5 per cent. In January 2010, the one-year and three-year returns were 3.5-6 per cent and 6.5-9 per cent respectively. The arbitrage funds have proved that they perform best, when there is volatility in the market.

…to retain retail interest

Since arbitrage funds enjoy a risk profile akin to that of debt funds or fixed deposits (which is why their returns are benchmarked against that of the money market), investors looking for low-risk investment avenues can consider allocating a portion of their funds parked in debt or fixed deposits in arbitrage funds. Arbitrage funds should be looked at as an alternative to fixed-income funds. Although there is a significant equity component in these funds, you should not compare them with equity funds and expect spectacular returns. These funds might score low on risk involved and liquidity needs. You get an exit window only once every month. However, arbitrage funds render stability to the portfolio and ensure positive returns in periods of panic.

The arbitrage funds are a win-win situation for you. It is the exact remedy for the volatility in the market. You should realize this and make the most of it. Now that you know how to make most of the volatility in the market, get the arbitrage advantage and make volatility pay back to you.