The Arbitrage Advantage

There are a number of investment options offered by mutual funds for those looking to invest with a time horizon of upto one year. To begin with, there are liquid funds and ultra-short term income funds for parking money for a period of three and six months respectively. For a time horizon of six to 12 months or so, there are short-term income funds, which have the potential to provide higher returns than savings bank accounts and short-term bank deposits. Despite their potential to provide better returns, these funds have yet to catch the fancy of retail investors in a big way. However, the scenario is gradually changing and retail participation in these funds is increasing.

Another category of funds which is not popular with investors despite being an effective option for shorter durations is arbitrage funds. An arbitrage fund is an equity-oriented scheme which seeks to generate income through arbitrage opportunities emerging out of mispricing between the cash market and the derivatives market. In other words, arbitrage funds capture the ‘interest’ element in the equity market and offer investors an opportunity to earn higher returns even without taking equity market exposure.

Let’s try to understand the strategy followed by fund managers of arbitrage funds. For example, a fund manager of an arbitrage fund may buy a stock at Rs 100 and sell its future at Rs 105. As a result, the manager would have locked a return of Rs 5 at the time of initiation of the trade. By the end of the expiry, their prices would generally converge to Rs 110. On unwinding the position, i.e. by selling the stock and buying the future, the profit earned on the stock would be Rs 10, whereas the loss from the future market would be Rs 5. Therefore, the net profit from the transaction would be Rs 5.

It is also important for investors to know that futures are traded in lots. Therefore, if the future contract of a stock has a lot size of 100 shares, the total return made through this strategy would be Rs 500.

As a result of the fund’s investment strategy, the fund manager is able to make money for investors regardless of the market movements. In reality, however, the ability of these funds to generate higher returns depends on volatility in the equity markets. Such volatility over the past couple of years has created good opportunities for these funds to generate healthy returns.

Here is a synopsis of the returns given by some of the arbitrage funds:

Performance Of Arbitrage Funds As On November 29, 2013

*Absolute ** Annualised
Past performance may or may not be sustained in future

While arbitrage funds have the potential to provide healthy returns, there are pitfalls too. A depressed stock market may not provide enough opportunities for an arbitrage fund. Besides, it is not necessary that the price of the stock and its future contract will coincide on the day of expiry.

Although arbitrage funds fall in the category of equity funds, they are not risky as they invest in stocks and their futures simultaneously. This eliminates the risk of volatility normally associated with equity funds. 

Moreover, they score over income funds in terms of tax efficiency as the tax benefits of equity funds are applicable to these funds. Therefore, any capital gains arising out of the sale of units after one year are tax-free. Short-term capital gains, i.e. gains on units sold within one year, are taxed at a flat rate of 15 per cent. In addition, any dividend paid by arbitrage funds is tax-free in the hands of investors. Even the fund houses are not required to pay any dividend distribution tax (DDT).

Hemant Rustagi
CEO, Wiseinvest Advisors