Profiteering through Arbitrage funds

Since June 2014, three asset management companies (AMCs) have launched arbitrage funds, therefore taking the number of funds available for investors to 14. Especially post-budget, these funds have garnered a lot of attention as a substitute to short-term debt funds. 

Neeti Trivedi, Partner, Acumoney Consulting says, “Arbitrage funds always existed but returns in short term debt funds were always comparable owing to which these funds did not really garner investor interest. Post the Budget, the changes in taxation of debts funds have made debt funds rather unattractive for short term investments.” 

Over the last one year, ending on August 8, 2014, the best performing fund in this category was Kotak Equity Arbitrage Fund with returns of 10.03% and the worst performing fund was Birla Sun Life Enhanced Arbitrage Fund 8.10%. As a category these funds tend to outperform in volatile market. 

Should you invest?

“Not a good time to invest in arbitrage funds. Arbitrage funds are good investment in a sideways market but now when we are looking at a possible bull run. Now if we look at the debt market then most probably we will witness a downward interest rate cycle. In such a scenario it is a very good opportunity to invest in debt funds. Hence, against the equity as well as debt funds, we are not recommending arbitrage funds under current market environment to our long term investors,” says Rohit Shah, Founder of GettingYouRich. 

Vidya Bala, Head of Mutual Fund Research, FundsIndia.com opines, “Arbitrage funds need not be timed. They are basically funds used to hedge or limit risks. Hence, one can invest in them any time.” However, she adds, that investors need to understand that arbitrage funds work best during volatile markets when the fund gets arbitrage opportunities between cash and derivative segment.

Meanwhile, Lakshmi Iyer, Chief Investment Officer (Debt) and Head Products, Kotak Mutual Fund believes that at the current juncture, there are reasonably good arbitrage opportunities in cash and futures equity market. She says, “Given that the bullish undertone in the market is likely to continue, we believe that it is appropriate to look at equity arbitrage funds now.” 

Seemant Shukla, Associate Director, Edelweiss Asset Management says, “If you were to look at the category since 2007, when the markets have seen multiple cycles, there have been just 3-4 months in 2008, when there were no significant arbitrage opportunities.”

“With its equity orientation, the dividends are tax free and the capital gains are tax free too, if the units are held for more than one year, making it more tax efficient than Liquid and Debt Schemes,” says Shukla. Hence, he recommends that arbitrage funds should be a part of all asset allocation strategies.

“Arbitrage funds, although categorised as equity funds, can replace some portion of the money lying in liquid funds. These funds do not qualify as a long term investment for generating wealth but are more an instrument for parking short term money. Not more than 5-10% of the portfolio depending on the overall asset allocation should be allocated to this category of funds,” says Trivedi of Acumoney Consulting. Since most funds have exit load upto 3 months, hence minimum holding period should be at least 3 months.

Adding a word of caution Trivedi says, “However, with a slew of NFOs and additional investments into these funds and with the limited arbitrage opportunities, it remains to be seen if the funds indeed can keep up the performance,” says Trivedi.

Do they always maintain 65% equity?

Many arbitrage funds in their mandate mention that they invest in debt products when they are not able to find investment opportunities on the equity side. Hence leaving the fear for investors that the debt allocation can get more than 35% and hence it may not qualify for taxation benefits. 

Bala of FundsIndia considers the flexibility as a good sign. She says, “It is a good strategy for fund house to give themselves the leeway to invest in debt if arbitrage opportunities are hard to come by. This is better than the risk of holding unhedged allocation in equity.”

Trivedi adds, that funds need to stick to the mandate to avail the tax benefits relating to equity funds. The reason why it is difficult for investors to gauge the level of debt position in an arbitrage fund is due to their derivative transaction. “The funds would typically ensure that they invest at least 65% into equity. Since this includes the derivative transactions as well, the funds typically would be able to maintain the stated allocation,” says Trivedi. 

Volatile market or Unidirectional market 

An important question that arises is does arbitrage fund perform only in volatile market or does it perform in unidirectional market as well. 

In volatile markets the price arbitrage between cash and derivative segment tends to have a high spread, thus providing opportunities to make profit.

Shukla of Edelweiss Asset Management says, “If you analyze the data of Arbitrage Funds since 2007 and split it further in periods where either Nifty has moved significantly upwards or significantly downwards, you will observe that the base case returns delivered by Arbitrage funds have been closer to 7-8% and the highest returns has been closer to 10-11% - proving that these funds can deliver stable and consistent returns across market cycles.”

Meanwhile, Iyer explains that arbitrage funds also performs during bull market. She says, “Arbitrage funds typically tend to do well in a market where sentiments are a tad bullish, as futures tend to trade at a premium during such times.” She further adds, volatilities also do offer opportunities for trading some portion of the portfolio.

Further explaining Shukla says that the price of a stock trade at different levels in the Cash market and the Futures market. The differential in the price is primarily because there is a risk premia attached to take exposure in the Futures market. This differential is closely linked to the risk-free rate existing at that point in time. 

“Thus, irrespective of the market movements the differential in the Cash and Futures markets will always exist – what will differ is the rate of differential. This will ensure that the Arbitrage opportunities exist even if the markets are unidirectional/range-bound,” says he.

ELEMENTS

An Example of Arbitrage Investing 

In simple terms Arbitrage is the simultaneously buying and selling of the same asset across two different markets in a way that the investor profits from the price difference. Since there is a simultaneous act of selling and buying, arbitrage is considered to be risk-free since the two positions automatically hedge the price risk of the asset going up or down in value. While there are many different strategies for arbitrage trading, allow us to share two examples. 

Cash-Future arbitrage --

Suppose Tata Motors' equity is trading at INR 100 on the NSE. Meanwhile, the 1-month Futures contract is trading at INR 110 on the NSE. The trader can buy the underlying and sell the Futures contract.

Since Futures contracts are traded in lots, the trader should execute the same number of shares. Since Tata Motor's has a lot size of let's say 50, the trader should purchase 50 shares of Tata Motor's at INR 100 and sell one lot of Tata Motor Futures at INR 110.

Now, the trader has two options. As the price difference between the Futures price and the Equities price is INR 10, he needs to wait for the price difference to be lower than INR 10 to earn a profit. If this is not possible, he can hold the positions overnight and execute the reverse trades on a future date.

Spot arbitrage -- (In India MFs are not allowed to delve into spot arbitrage)

To put it as an example. Tata Motor’s shares are trading at INR 100 on the BSE and is available for INR 110 on the NSE. Then an astute trader would simply purchase the shares at INR 100 from the BSE and sell the same quantity for INR 110 on the NSE, thereby registering a profit of INR 10. Since cross-clearing has not been approved in India, the trader would need to sell the BSE shares and purchase back the NSE shares within the same day to capture the profit. Therefore, even after paying for all transaction costs, the trader would reap in some profit. 

Options of Arbitrage Funds

Fund	2007	2008	2009	2010	2011	2012	2013	1-Year Return (%)
Kotak Equity Arbitrage Fund	9.06	8.30	5.15	6.31	7.51	9.58	9.18	10.03
ICICI Prudential Blended Plan	8.79	9.25	3.53	6.39	7.69	10.47	9.45	9.73
ICICI Prudential Equity Arbitrage Fund	-	8.32	3.67	6.52	7.63	10.11	9.80	9.73
IDFC Arbitrage Fund	8.30	7.82	3.29	5.56	7.87	9.32	9.23	9.68
JM Arbitrage Advantage Fund	8.95	9.02	4.52	6.55	6.75	9.46	9.15	9.68
SBI Arbitrage Opportunities Fund	9.23	8.33	4.14	5.76	8.34	9.11	9.03	9.29
IDFC Arbitrage Plus Fund	-	-	3.28	5.54	6.54	9.07	8.95	8.82
UTI SPrEAD Fund	8.84	10.60	6.41	4.83	8.36	8.65	7.66	8.79
Reliance Arbitrage Advantage Fund	-	-	-	-	8.32	9.89	9.70	8.74
Religare Invesco Arbitrage Fund	-	8.69	4.22	5.70	7.47	9.12	7.91	8.60
Birla Sun Life Enhanced Arbitrage Fund	-	-	-	5.41	7.12	7.06	9.45	8.10
Date as on August 8, 2014

NOTE: the reason of taking the returns from 2007 is to show the performance in bull run like 2007 and in 2009. 

P.S. This is the submission draft. The actual story had appeared in October issue of Money Today. You can read the final version. Click here or copy paste the given below link - http://businesstoday.intoday.in/story/arbitrage-funds-substitute-short-term-debt-funds/1/210796.html