ARBITRAGE FUNDS

Better alternative to bank FDs

ONE of the most important features of our equity markets is the successful introduction of derivatives. It has been so successful that daily volumes have propelled the market to become the second biggest equity derivatives market in the world. India possibly has the largest number of traded stock futures globally, with over 300 listed stocks in the derivatives segment. Derivatives have improved liquidity, but they have also heightened volatility, due to the huge leverage capabilities for investors. An ordinary investor may find it hard to trade in derivatives, but can safely invest through arbitrage funds, to get superior returns with seemingly no risk.
    Arbitrage means taking advantage of a price differential between two or more markets. It is the practice of simultaneous purchase and sale of an asset in order to benefit from the discrepancy in prices. The profit earned is known as “riskless profit”. Arbitrage mutual funds follow this principle, and seek to capitalise on mis-pricing opportunities in cash and derivatives markets. As arbitrage funds generate low-risk returns, they are seen in the same light as other low-risk options, like liquid funds or even bank fixed deposits. Hence, arbitrage funds are an excellent avenue for short-term investors with low risk tolerance who want slightly higher returns.
    The major attraction of arbitrage
funds is the near risk-free returns. Arbitrage funds have no open exposure to equities—all equity positions are hedged. A buy position in a particular stock in the cash market is hedged by a simultaneous sell position in the futures market. So, irrespective of the share price, the fund earns the spread between the purchase price of the shares and the sale price of the futures contract. Hence, although arbitrage funds predominantly invest in equity and equity derivatives, the returns are generally in line with those from debt-oriented funds, averaging between 8% and 12% for investment periods of 3-6 months.
    Arbitrage funds strive to generate fixed income using a mix of hedged stock futures, debt and money market instruments. To put it simply, arbitrage is the action of buying a stock at Rs 100 and selling its futures contract at Rs 105, giving a riskless profit of Rs 5, which also becomes the interest cost of funding the transaction. This is also called the cost of carry. So if a mutual fund holds 10,000 shares of Reliance Industries with a current market price of Rs 2,400, to create an arbitrage opportunity, it will sell the near-month futures contracts at Rs 2,500. The fund thus nets an arbitrage or differential of Rs 100, which also becomes the cost of funding the purchase of shares at Rs 2,400 for one month. This transaction has no risk, as it is hedged through simultaneous buy-cash and sellfutures actions. So, no matter what the closing price of Reliance Industries on the contract expiry date, the profit or differential of Rs 100 is locked at the time of executing the transaction.
    Taxation is another area where arbitrage funds score over debt-oriented funds. Barring a few schemes categorised as debt-oriented funds, most arbitrage funds are categorised as equity funds for taxation purposes. Accordingly, arbitrage funds attract 10% Short-Term Capital Gains Tax (STCG), whereas Long-Term Capital Gains (LTCG) are exempted from taxation. And dividends are tax-free.
    Thus arbitrage funds are much superior to debt-oriented funds, where STCG is taxed at 30%, and LTCG at 20% with the indexation benefit (or 10% without the indexation benefit). Other fixed-income products like bank FDs are similarly subjected to the investor’s marginal rate of taxation. So post-tax returns of arbitrage funds tend to be higher than from FDs.
    Although the purpose of arbitrage funds is to generate risk-free returns, these funds are not without risks. Futures contracts are traded in lots, so risk arises from lower liquidity in the cash or futures segment of a given stock. If a stock lacks liquidity, all the shares bought against its futures contract may not be sold. Similarly, on the date of expiry when the arbitrage position is to be unwound, it’s not necessary for the stock price and its futures contract to coincide, leading to imperfect execution of the arbitrage strategy. But such risks are negligible, and most fund houses have an online mechanism to monitor liquidity in stocks and futures contracts where they are invested.
    Arbitrage funds are relatively new in India. The first such fund was launched in 2005 by JM Mutual Fund, called JM Equity & Derivative Fund. These funds have shown robust growth, with cumulative assets under management growing from around Rs 3,605 crore in January 2007 to around Rs 6,000 crore in January 2008. The largest of these funds is ICICI Prudential Equity & Derivatives Fund, with assets of over Rs 1,200 crore, followed by Standard Chartered Arbitrage Fund with a corpus of around Rs 1,000 crore as of January 2008.
    Arbitrage funds have fared well, averaging an annualised return of 10%, 9% and 9.50% respectively for the three-month, six-month and one-year periods. HDFC Arbitrage Fund, ICICI Prudential Blended Plan, Kotak Equity Arbitrage Fund, Lotus India Arbitrage, JM Arbitrage Advantage Fund and SBI Arbitrage Opportunities Fund are some funds which have consistently delivered good returns.
    From an investment perspective, arbitrage funds are ideal for investors wanting to park their short-term surpluses. The returns of arbitrage funds are dependent on the prevailing cost of carry, which can be volatile depending upon market conditions. It is observed that during bullish market phases, the requirement of funds shoots up thereby giving higher cost of carry whereas in bearish market conditions, the fund requirements are low thus offering low cost of carry. Investors are thus expected to invest with a minimum time window of at least three-six months to enjoy stable returns.

Times of India Mumbai, 19th Feb 2008, Page 45

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