FUND FLAVOUR

March 2017

Safety, tax efficiency…

Is there any mutual fund scheme as safe as debt mutual funds with better taxation for short term and long term gains? Yes. There is a set of mutual fund schemes which offers the above-mentioned features. They are called Arbitrage Funds. Arbitrage fund is an equity based mutual fund which provides consistent performance, similar to debt mutual funds, but is taxed like an equity based fund. Arbitrage funds are classified as equity funds from the taxation perspective. This is the best part. It means, you are taking less risk (similar to debt funds) but getting better taxation benefits of the equity funds. Effectively, they provide consistent returns like debt fund, and do not fluctuate much like equity funds do when the stock market goes up/down.

…consistency et al

Let us understand the concept of how arbitrage funds actually work. These funds invest in something called “arbitrage opportunities” in the market. The opportunities occur where there is a difference in the prices of a share at two different times/locations. It can be a difference in share prices at a moment in BSE and NSE exchanges, or it can be a difference in the prices of the stock in spot and F&O market. When such an opportunity occurs (and it almost always does), these funds buy and sell the shares at the same time in two different markets. They buy the share from where it is cheaper and at the same time sell it where it is expensive. This way, they earn some money and this money is called the arbitrage money. As they buy and sell at the same time, there is not much risk involved. Even if the stock prices go high or low, it does not make any difference to them because they have already earned their money. This is the reason why these mutual fund schemes are able to offer consistent performance over time.

Risk-free profit opportunity

Arbitrage means a risk free profit opportunity. So, by definition Arbitrage funds are very safe. However, safety of a financial instrument can again be divided into two parts:

1.      Assurance of capital protection

2.      Assurance of returns

As far as a bank FD is concerned, your money is safe on both aspects, i.e. your capital is protected and return is guaranteed. However, in arbitrage fund, only the first one holds true. Since arbitrage itself means risk free profit opportunity, there is virtually no risk of the fund value going down (once in every few days, the NAV may fall by a bit though).
But when it comes to assured returns, it is not offered by arbitrage funds. Your returns will be variable and you cannot be sure of how much profit you will earn. Arbitrage funds are not as safe as bank FDs, but compared to other mutual fund types, it has the potential to provide higher returns at much lower risk. And of course, since the returns are tax free after one year, your after tax gains may be higher than bank FDs. Arbitrage funds (mutual funds) take advantage of the arbitrage opportunities in the equities and futures (derivatives market) and invest. Derivatives market price the differential, that is known as carry cost. Arbitrage funds are able to capture this and pass it on to you. Returns will not be phenomenal. It will range between 8 and 10% per annum. What you can be sure about is that principal will be intact. There will no risk of NAV coming down. 

Minimal risk is one of the biggest advantages of arbitrage funds. Since each security is bought and sold at the same time, there is almost no risk associated with long-term investments. Besides, these funds invest partly in debt securities that are largely considered as stable. If there is a shortage in profitable trades, the fund may invest heavily in debt, which makes them appealing to investors having a low-risk appetite. Arbitrage funds are perhaps the only low-risk investment instruments that can flourish in volatile markets. Volatility causes uncertainty among investors. The difference between futures and cash market burgeons. Stable markets mean individuals share prices are not showing much change. Sans any clear bearish or bullish trends that may reverse or continue with the status of the market, investors will not have reason to believe that equity prices over a one-month horizon will change drastically from the current levels. Risk and volatility go hand in hand. You cannot pocket huge gains, or suffer big losses, without either. These funds are a great choice for risk-averse investors who want to reap the benefits of a volatile market, but with negligible risk.

Risk factors of arbitrage funds

Arbitrage Risk:

There is an amount of risk factor in Arbitrage Funds as well. It is the risk of spotting the rightful arbitrage opportunity in the market and acting upon it before the thought is over, i.e. very quickly. This is because the price difference will no longer exist when people realize the difference in the prices! So the arbitrage opportunity will then cease to exist. Thus, the opportunity needs to be identified and acted upon even before the opportunity actually arrives!

Liquidity Risk:

An arbitrage fund, unlike a Liquid Fund takes 3 days to be redeemed and your account to be funded whereas in a Liquid Fund, the amount gets credited into your account in one day. An arbitrage fund, being classified as equity due to taxation advantage, and redemption will materialize after T+3 days, thereby losing float for 2 interim days. However, a Liquid Fund gets credited into the account on redemption in T+1 day.

Exit Load Risk:

Some, almost all, arbitrage funds have an exit load of 60-90 days unlike that of liquid funds. Thus, any money, which is definitely there for a period of 3 months to a year’s time can be invested in this fund over liquid funds.

Arbitrage fund performance

Most Arbitrage funds follow a similar investment mandate. Under normal circumstances for instance, Birla Sun Life Enhanced Arbitrage Fund, HDFC Arbitrage Fund, and IDFC Arbitrage Fund invest between 65 to 90% in equities and derivatives and the remaining 10 to 35% in debt instruments. Invesco India Arbitrage Fund, on the other hand, allocates between 65 and 80% in equities and derivatives and the balance 20 to 35% in debt and liquid instruments. However, in exceptional circumstances, when arbitrage opportunities become unavailable, their asset allocation can shift to safer debt instruments, with 65-100% holdings in them; equities and derivatives will then make up the rest. Some funds may even impose a cap on purchases. For instance, ICICI Prudential Equity-Arbitrage Fund imposes a cap of ₹10 crore per investor. Effective July 2016, the fund changed its benchmark from CRISIL Liquid Index fund to Nifty 50 Arbitrage Index. Arbitrage fund returns depend on prevailing interest rates in the market and the availability of arbitrage opportunities. For instance, over the last year, while the Sensex and Nifty 50 were flat, these funds managed to gain around 6.4%, at par with the liquid fund indices. During a three-year period, as the broader markets gained around 15%, the returns from these funds were around 8%. However, over a five-year period, the gap reduces For Arbitrage Fund, the fund category returns over the one-year, three-year, five-year, and ten-year period historically is 6.5%, 7.88%, 7.98%, and 7.74% respectively. Thus, Arbitrage Funds have historically given 7-8% return over 5 to 10 years and top performing Arbitrage Funds have done better by about 1%. Thus returns of top performing arbitrage funds have mostly varied from 8-9%. Average returns were around 8% while the Sensex posted gains of 10%. As investments are based on price differentials, the expense ratio of arbitrage funds tend to be lower than that of diversified equity funds, thereby boosting overall returns. While the expense ratios of the actively managed funds are in the 2-2.5% band, arbitrage funds report a much lower 0.5-1%.

Less understood and under-purchased

Arbitrage funds are treated as quasi liquid as they bear almost the same risk as liquid funds but benefit from more advantageous taxation rules. And yet the total assets under management (AUM) of arbitrage funds stands at just Rs.22,000 crore as against that of liquid funds, which stands at around Rs.3 lakh crore. This lack of enthusiasm from investors may possibly be because they have little or no information about arbitrage funds and do not understand its potential, especially when compared with other types of funds in the same category of investment horizon such as liquid funds. Arbitrage Funds are one of the least understood types of funds and people who understand it, are the ones who make the most of it.

Rising popularity of arbitrage funds

Arbitrage funds have gained popularity among investors due to its favorable tax treatment ever since Union Budget 2014 tweaked taxation rules that favoured them. This is evident from the fact that arbitrage funds are now 33% of overall net inflows in equity funds. AMFI data shows that of the Rs.46,000 crore of net inflows in equity funds, Rs.15,000 crore has come through arbitrage funds in April-December 2016. The data further shows that arbitrage funds constitute 35% of gross sales under equity schemes. In fact, AUM under arbitrage funds stood at Rs.37,891 crore out of 419,562 crore in equity funds as on December 2016 which is about 9% of total AUM under equity schemes.

Arbitrage is the answer

There is a perception among investors that arbitrage fund is an all season fund due to low risk assets in the portfolio. It is expected this fund will perform well in bull as well as bear markets. An arbitrage fund usually performs well in a volatile market as the probability of mispricing increases. When the market is on its bull trend, investments in equities in portfolio stand to benefit as futures are usually high priced than the cash, thus fund managers sell the futures and buy the stock in the cash market thus booking risk free return. However, these funds face a challenge in a bearish market as the future would be less priced than the stock. Thus, arbitrage opportunity vanishes. Invest in arbitrage funds in a tactical manner to replace some portion of liquid and short term debt funds in overall portfolio with a view to earn better tax efficient return in bullish and volatile markets. If you are looking for debt investments with equity taxation benefit, or 6-9% returns without any equity exposure and yet reap the benefits of equity investment, then Arbitrage Funds is the answer to your needs!