Ever wondered if it is possible to generate positive returns even from volatile market conditions without taking much risk….????? If yes, read through.

Of late, there has been an avalanche of bad news flowing out of the Indian stock markets. The Sensex tottering around the 10K mark, the Nifty around the 3K mark, plummeting stock prices of most companies, mutual funds failing to garner any positive returns… the list seems to go on and on, and on. Amidst all of these sob stories, we have become almost desperate for some positive information.

While the markets have been crashing around us, there has been one category of mutual funds that have actually generated returns in the green. They are the Arbitrage Funds. Quite often referred to as equity-and-derivative funds, arbitrage funds are an ideal way of earning a reasonable income from equities with the modest amount of risk.

First of all, let’s understand the word- Arbitrage.

In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

When used in academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit.

A person who engages in arbitrage is called an arbitrageur - such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

In finance parlance, arbitrage is defined as the sale and purchase of some securities in different markets to profit from the unequal prices. Stocks usually trade at different prices in different markets. Aided by sophisticated software, mutual fund companies identify stocks with price differential in cash and future markets and make profits on it. Although the difference in prices is not much, it is good enough to generate returns to the tune of 7-10 per cent even in these markets.

Arbitrage funds- A category in mutual funds

Investors not familiar with this type of scheme might just end up thinking that these are just equity-oriented schemes with another fancy name. However, this is not so.

 The objective of an arbitrage fund is to capitalize on a stock’s price difference between the spot market (cash segment) and the derivatives market (futures & options segment). These funds basically generate income by taking advantage of the arbitrage opportunities arising out of the mis-pricing between the two markets (spot and derivative). You can enter in these funds anytime & not worry where the market is headed.

Let’s illustrate this concept with a hypothetical situation. The stock price of XYZ Ltd. is quoting at Rs.600. Let’s say the stock is also traded in derivatives segment, where its future price is Rs.610. In such a case, one can make a risk-free profit by selling a futures contract of XYZ Ltd. at Rs.610 and buy an equivalent number of shares in the equity market at Rs.600.

Now when settlement day arrives, it wouldn’t matter which direction the stock price of XYZ Ltd. has taken in the interim. In other words, it is irrelevant whether the share price of XYZ Ltd. has risen or fallen, one would still make the same amount of money.

This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place — buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, the investor earns the spread between the purchase price of the equity shares and the sale price of futures contract.

Why one should invest in Arbitrage funds…

Arbitrage schemes are recommended for investors who have a low-risk profile.

Arbitrage funds are ideal when there is no direction in the market, or in times of uncertainty.

In the case of arbitrage funds, if the market goes up by 50 per cent, these funds will give returns of around eight per cent, while if the market goes down by 50 per cent, they would still give a return of six to seven per cent.

Arbitrage should be looked at as an alternative to fixed-income funds. Over the last one year they have given returns between 6 and 9.5 per cent. Also, with the interest rates softening, these schemes will give better returns compared with a bank deposit, as the income generated is tax free after one year, at the hands of the investor.

Arbitrage mutual fund schemes are allowed to invest 0-100 per cent in equities, derivatives and money market and debt instruments.

Although there is a significant equity component in these funds, you should not compare them with equity funds and expect spectacular returns. Such funds render some stability to the portfolio and ensure positive returns in times like these. It is advisable to allocate a small part of your portfolio to such schemes.

Tax treatment

As these schemes are tilted heavily towards equities (65 per cent or more), the tax treatment is the same as equity schemes. Investments made for less than one year attract short term capital gains tax of 15 per cent and in case investments are held on for more than one year, the profit earned is not taxable.

To Conclude

Sounds highly appealing, doesn’t it? Well, arbitrage funds have clearly outperformed debt funds and the returns of an arbitrage fund become tax-free after a year, but these funds have a few concerns as well. The main concern would be a bloating asset size.

If the AUM of an arbitrage fund increases heavily, then a majority of the assets would remain parked in money market instruments simply because of the lack of enough arbitrage opportunities. However, it is not time to be overly concerned as yet because more and more stocks are being introduced in the derivative markets, hence broadening the investment universe for arbitrage funds.

So, should you opt for an investment in arbitrage fund? The facts and figures sure support the cause. Arbitrage funds offer better returns than debt or income funds and their earnings become tax-free after a year. But, increasing assets could be a cause of concern, albeit not yet.

The category currently manages a moderate amount of assets and is made up of 10 funds. But the deciding factor could be that arbitrage funds generally thrive on volatility. The higher the volatility in the markets, the higher is the potential of mis-pricing between the spot and derivatives markets. Hence, at a time like now, when the markets are at their volatile best, arbitrage funds might just turn out to be the most favorable form of investment.

Apart from this, one must keep certain points in mind:

• Arbitrage funds usually have an exit load for investment period less than 3 months. So make sure that you won’t need this money for at least 3 months.
• The returns are linked to expiry of contracts (which happens on the last Thursday of the month). So you need to be a bit careful about your redemption dates.

Concluding, therefore, one can say that arbitrage funds can be a good alternative to invest our short-term money, where we can earn high post-tax returns – with reasonable degree of safety & surety….!!!!!

Top 3 Arbitrage funds

These are 1 year returns

GRAB THE OPPORTUNITY; THIS IS THE TIME…..!!!!!

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This entry was posted on Monday, February 16th, 2009 at 7:55 am and is filed under Mukesh Dedhia's published articles. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.