FUND FLAVOUR

March 2018

Steady Returns at Zero Risk of Capital Losses

Can you name an investment that offers steady returns and offers zero risk of capital losses? Arbitrage Funds is the answer. Arbitrage funds are a type of equity-oriented hybrid mutual funds that generate returns through the simultaneous purchase and sale of securities on different exchanges that feature a pricing mismatch. This is a diametrically different approach from that of the typical equity fund, where the fund invests in equities and holds those till they can be sold at a profit in the future. In case of an arbitrage fund, the fund would typically buy a security from the cash market (stock market) and simultaneously sell the same security on the futures contracts market at a different price in order to generate a profit in the overall transaction. In a majority of cases, the difference between futures contracts and stock prices is small, hence on an average, arbitrage funds have to make hundreds of trades in a day in order to turn a profit. A secondary route of investment for arbitrage funds are short term debt and money market instruments. However, these form a relatively smaller portion of the arbitrage fund’s overall portfolio.

Arbitrage Fund – a unique class

The following are some of the key features that make arbitrage funds a unique class of mutual funds in the hybrid funds category.

Equity-Based Investments: Arbitrage funds are mainly invested in equities as well as futures i.e. equity derivatives. On an average, these comprise at least 65% of the mutual fund’s portfolio. Thus for purposes of taxation and classification, arbitrage funds are considered to be equity-oriented hybrid funds. Apart from the equity portion of the portfolio, arbitrage funds also invest in a range of debt and money-market instruments including cash. The portion of these secondary investments tends to be higher when arbitrage opportunities are limited during periods of relative market stability.

Perform Best in Volatile Markets: An arbitrage fund performs best when there is an opportunity available to the fund as a result of the price differences in the spot and derivatives markets. When markets are expected to be stable in the long term, this difference in pricing is minimal hence traditional arbitrage transactions might not generate a profit after securities transaction charges/brokerage is factored in. On the other hand during periods of volatility, there is often a marked difference between the spot and futures prices, which provides arbitrage funds with an opportunity to score big. This is the main reason why the portfolio of an arbitrage fund tends to feature a greater value of equity investments during periods of high market volatility, while debt investments tend to increase during periods of relative market stability.
Equity investments limited by availability of futures contracts: Arbitrage funds in India have limited scope of making equity investments because they can only buy shares traded on the exchange that have futures contract options available. The Indian derivatives market is relatively less developed than many other advanced markets which somewhat limits the scope of arbitrage-style investments. This limitation arises from the fact that arbitrage funds cannot make an equity investment without having the option of hedging it with a futures contract (i.e. no naked positions/options are allowed). As a result of this limitation, there are fewer arbitrage funds currently available in India as compared to many other advanced financial markets such as the US.
Dividend Earnings and LTCG  taxed: Dividends in case of mutual funds are not taxable when in the hands of the investor. This holds true for all equity, debt and hybrid funds that are available for investment in India. However, dividends obtained from non-equity mutual funds are subject to a dividend distribution tax (DDT) of around 30% (28.84%) , which is payable to the government directly by the fund house. This tax expense is eventually passed on to the investor as part of the fund’s expense ratio. In case of an equity-oriented scheme such as an arbitrage fund, the dividends paid out to the investor is taxed at 10% DDT. From 1st April 2018, a Long-term capital gain of equity mutual funds exceeding Rs. 1 Lakh will now attract a tax of 10%. This taxation will be without the indexation benefit. Under this new rule, LTCG from even equity oriented hybrid funds like Balanced funds and Arbitrage funds will also be taxable. The short-term capital gain arising from the sale of units within 12 months of investment will continue to be at a flat rate of 15%. If the investor continues to stay invested and sells equity funds later on then his/her long-term gains up to 31st Jan 2018 would be exempt.

High Turnover/Expense Ratios: In case of an arbitrage fund, the key method of investing is to make repeated purchases and sales of the same securities simultaneously on the stock market and the derivatives markets. This process of buying and selling gets reflected in the turnover ratio of the arbitrage fund as no stock or futures contract can be held for a long period of time. Hence, an arbitrage fund will tend to have a higher turnover ratio (often around 800% or even more) as compared to most other types of mutual funds. Transactions made on the securities or derivatives markets are subject to various brokerage fees as well as applicable taxes. These transaction charges are expenses that the mutual fund includes in its expense ratio and passes on to the investor. As mentioned earlier, an arbitrage fund tends to perform numerous buy/sell transactions in a day in order to generate adequate returns. Hence it will tend to feature a higher expense ratio as compared to many other types of mutual funds.

Low Risk Investments: An arbitrage fund hedges its bets through simultaneous transactions on different markets. As a result of this hedging, an arbitrage fund can potentially make a profit no matter which direction the market moves. This is a unique feature in case of a mutual fund and therefore an arbitrage fund is considered to be a low risk investment, which is considered suitable for risk-averse investors seeking low risk equity-oriented investment options.

Bears, Bulls and Arbitrage Funds

The general investor perception about Arbitrage Funds being all weather birds needs a relook. These funds leverage on the mispricing of securities. During the bull-run, the probability of mispricing increases on account of high volatility. Moreover, the futures tend to be priced higher than the cash segment, i.e., equities. Consequently, investments in stocks in portfolio stand to gain. The fund managers sell the futures and buy the stock in the cash market, thus booking risk-free return. During bear runs, futures tend to be priced at a discount, i.e. below the stock price. The arbitrage opportunity hence disappears.

Returns can swing

Cash futures arbitrage helps funds earn their returns in regular monthly doses, thus making them a good option for regular income seeking investors. On this count, arbitrage funds are less risky than debt funds because they do not take on interest rate or credit risks which can cause NAV blips. But this is not to say that Arbitrage fund returns are fixed. They can vary from month-to-month and year-to-year. In June 2015, Arbitrage Funds sported one-year returns ranging from 7.1 to 8.7%, with a three-year CAGR of 8.5%. But in June 2017, returns are much lower, ranging from 5.5 to 7.3%, with a three-year CAGR of 7.2%. The returns from Arbitrage Funds, as a class, are influenced by three factors. One, the spread which can be made on cash-futures arbitrage can rise or fall with short-term interest rates in the market. Two, the spreads are also dependent on the participants in the arbitrage market. Three, if markets are volatile or bullish, traders are willing to pay higher interest costs, to buy futures widening the spread. In bear markets, interest in derivatives can wane, thinning out arbitrage opportunities and returns. Investors entering Arbitrage Funds now, can keep their return expectations moderate at the 6 to 7 % range.

                                      

How have Arbitrage Funds Performed?

Arbitrage funds look to exploit the price differences in stocks between the cash and future market. They are recommended to conservative investors looking to park money in the short to medium term.  The Arbitrage fund category average return in the last one year was around 5.5% and in the last 2 to 3 years the returns have been around 7%. The returns from Arbitrage funds have slightly decreased over the last couple of years. The returns on these funds are mainly dependent on the fund manager’s ability to spot arbitrage opportunities. As more funds and more monies chase the arbitrage opportunities, the returns can reduce. If you observe, the AUM of all the funds have increased tremendously in the last couple of years. ICICI Prudential Equity Arbitrage Fund’s AUM has increased from Rs 1,000 crore in 2016 to around Rs 11,000 crore in 2017. If you decide to invest in an Arbitrage Fund, consider opting for a Direct plan. The returns generated by the Direct Plan is 6.27%, 6.8% and 7.24% over one, two and three years respectively, better than the Regular Plan returns of 5.59%, 6.1% and 6.62% over the same time period. The Expense ratio of the Direct plan is 0.27% and for the Regular Plan it is 0.87%.

Arbitrage Funds – losing out on their edge over Debt Funds?

Arbitrage Funds started gaining traction in India since 2014 when liquid fund gains started getting taxed. Taxation and risk are the main factors which concern the investors most. Before 2014, short-term debt funds were considered as best option for risk-free returns from investment in mutual fund. After government reduced the tax benefits for debt funds, Arbitrage funds became popular. Arbitrage Funds became the “apple of investor’s eyes”, who sought risk-free and tax-free return on their investment. Its investment strategy to generate a return with less risk and taxation benefits have attracted a large number of investors. Arbitrage Fund returns have fallen in the past three years. From delivering 9-9.5% per annum not too long ago, they (as a category) delivered just 6.43% in the previous twelve months. Short Term Debt Fund returns, on the other hand, are on the rise - with a category average of 9.43% in the past year, which is very impressive for a low-risk instrument. Now with the new taxation policy in Budget 2018, Arbitrage funds are fast losing their tax advantage and are facing the peril of fading away from the portfolio of investors.

Be cautious of Arbitrage Funds with unhedged equity allocation

As arbitrage schemes began gaining traction, fund houses were soon to capitalise on the trend and launched a modified form of arbitrage funds. These funds, also known as Equity Savings Funds or in some cases Enhanced Arbitrage Funds, included an unhedged equity exposure. Equity Savings Funds are comparable to Monthly Income Plans that have a small equity component of 10%-20%. However, as Equity Savings Funds invest in equity Arbitrage opportunities instead of debt, they are treated as equity schemes and enjoyed tax advantage. However, due to the unhedged equity exposure, the risk involved is higher than pure arbitrage schemes. Hence, returns will be volatile. Risk averse or conservative investors seeking steady returns should ideally stay away from such schemes.

Points to ponder

•          Arbitrage Fund’s return is based on the volatility of the market. It doesn’t take any directional call in any stocks or in future market.
•          Arbitrage Mutual Funds offer investors high liquidity and better returns than savings bank account. Most of the Arbitrage Mutual Funds do not charge exit loads for redemptions after 7 - 30 days of investment.
•          Arbitrage Mutual funds can give good short term returns in volatile markets which is comparable or even higher than liquid funds and ultra-short term mutual funds
•          Investors should be prepared for very short term volatility before expiry of futures contract (last Thursday of every month). Sometimes the fund manager may find better divergence between spot and futures price in later monthly series relative to current month series of F&O contracts; which implies that the investor may have to wait a little (two or three months) longer.
•         You can invest lump sum amounts in these funds for short-term goals. Systematic Investment Plan (SIPs) in these funds may not really make sense.
•          The fund is not a substitute of the debt fund, both have different investment objective with different risk factors.
•          You can consider these funds as one of the saving options when you are building your emergency fund.
•          Arbitrage opportunity is not present in the market at all times.

From the above analysis, we can say that arbitrage schemes are an apt choice if your holding period is less than three years. Arbitrage funds are for conservative investors with investment horizon of 1 to 3 years. For investors having a horizon of less than 6 months, ultra short-term debt funds will be the best bet as compared to Arbitrage Funds. The difference in taxation makes a significant transformation in the net returns. Like with all investment avenues, you need to choose wisely. Prudent investing and financial discipline are vital ingredients for long-term financial well-being.