Fenil's Library

The category stands out for the tax advantage and stability in returns it offers

ICRA Online Research

Continuing our series of less popular equity fund categories that have done well in the current equity market meltdown, we talk about the arbitrage funds this week.

Unlike the run of the mill equity fund, arbitrage funds skirt the ‘high risk’ tag that is synonymous with equity investment. But then again, the returns are also much lower and closer to those of debt-oriented funds. 

The obvious question, of course, is how these funds manage to keep the risk so low. We first look at the performance of these schemes, and then explain why it makes sense to invest in them. 

Performance 

The benefits of arbitrage schemes are best enjoyed during volatile markets, primarily due to the stability in the investment strategy of such schemes. 

To attain the returns with bare minimum risk, the asset allocation of arbitrage scheme is split mainly between equity and debt components. 

The basket of 10 arbitrage schemes has provided an average return of 7% over the past one year, which is lower than those of the ultra short term debt funds.

Over the past two years, these funds have done better than the liquid fund category.

However, if we consider the tax advantage that the equity oriented (discussed later in the article) arbitrage funds offer, the post-tax returns of arbitrage funds look much better.

A look at the year-on-year performance, albeit short, gives us an idea of the kind of stability these funds offer.

At this juncture, we must also speak about UTI Spread Fund, which has managed to clearly beat the category. Investors need to be forewarned that the scheme has since January 2008 been functioning more as a debt-oriented fund. From an average equity allocation of 68-70%, the scheme’s equity allocation over the past 15 months has been in the range of 0-22%. While this movement in the fund’s asset allocation has been noteworthy in producing results, it may have in the bargain lost its equity oriented tag.

The arbitrage gain is achieved by taking advantage of the mispricing between the cash and the derivatives markets.

For example, say the stock price of A Ltd is quoting at Rs 100. Let’s say the stock is also traded in derivatives segment (not all scrips are traded in the derivative segment), where its futures price is Rs 110. In such a case, one can make a risk-free profit by selling a futures contract of A Ltd at Rs 110 and buying an equivalent number of shares in the cash market at Rs 100. Now, when settlement day arrives, it wouldn’t matter which direction the stock price of A Ltd has taken in the interim. In other words, it is irrelevant whether the share price of A 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 —- first, buy stock; second, sell futures; third, sell stock; and fourth, buy futures. In this manner, irrespective of the share price, the investor earns the spread of Rs 10 between the purchase price of the equity shares and the sale price of futures contract. 

Generally, asset allocation is taken as a measure to judge the risk associated with the fund’s investment. Under normal circumstances, the indicative allocation will be in the range of 65-90% in derivatives including index futures, stock futures, index options and stock options, and the remaining 10-35% in money market and other debt instruments. On the other hand, when there is unavailability of arbitrage opportunities, investments will be in money market instruments. • 

When a company merges with or is taken over by another company, there could be arbitrage opportunities due to mispricing of the scrip. When the company announces the buyback of its own shares, there could be opportunities due to price differential in buyback price and traded price. At the time of dividend declaration, the stock futures or options market can provide a profitable opportunity. Generally, the stock price declines by the dividend amount when the stock goes ex-dividend. The mispricing across different indices can lead to arbitrage opportunities for the fund.

It is not all smooth sailing for these funds. There can be instances where the fund manager cannot find an arbitrage opportunity in the market. During a given time period the market may or may not provide any meaningful arbitrage opportunity. For this very reason, such schemes cannot assure returns; the returns totally and completely depend on available opportunity. In the absence of arbitrage opportunities, the fund manager is most likely to retain the money in liquid fixed income instruments. This would affect the returns of the funds and make them akin to a liquid fund. This eventuality has so far not arisen in the case of arbitrage funds in India, although these schemes are still quite young. There have also been cases where fund managers have refrained from taking arbitrage opportunities. 

All the transactions in the stock market involve payment of brokerage and security transaction tax (STT). These costs straightaway eat into the profits earned. Each leg of the transaction, i.e. buying stock, selling future, selling stock and buying future, will entail payment of these costs. Therefore, it is just not enough for an arbitrage opportunity to exist; the spread needs to be meaningful enough to cover the costs.

Arbitrage funds are meant to be a long-term investment opportunity, even though they capitalise on short-term arbitrage opportunities. Fund managers will be the first to admit that attractive arbitrage opportunities are not easy to come by week after week, month after month. Arbitrage funds can fall in equity or debt category, depending on the exposure a fund has taken. If a scheme has an equity exposure of more than 65%, then it has an equity fund status, or else, a debt fund status. 

The fund will enjoy the same tax benefits that an equity fund has if it categorises as an equity arbitrage fund, that is, you pay no tax on capital gains, if these gains arise after a period of one-year. More than anything else, arbitrage funds enjoy an edge over debt funds mainly because of the tax benefit. To maximise this benefit, investors are advised to stick around for at least one year in an arbitrage funds. Also, some of these funds charge a considerable exit load for different tenures. Investors must check these details before committing money. 

We would recommend these funds primarily for the tax advantage and stability in returns they offer. The returns here are fairly stable and in line with fixed income instruments.