Riding volatility

Riding volatility

When markets get volatile — as they have been in the recent weeks — even seasoned investors find it difficult to understand equity investments.

Even in the best of times stock investing is for the brave hearts. When markets get volatile — as they have been in the recent weeks — even seasoned investors find it difficult to understand equity investments. Yet there is an investment instrument that not only withstands volatility but actually thrives on it. It’s arbitrage funds. A kind of mutual fund that invests in derivatives (stock futures) and debt instruments like bonds. By their very structure—arbitrage involves selling the more expensive instrument and buying the cheaper—these funds make the most of gyrating stock prices. The topping over the returns is that being equity funds, they don’t attract any capital gains tax if investment exceeds a year. That makes them a preferred option to put part of your financial savings in the current market situation.

Says Sanjiv Shah, executive director, Benchmark Mutual Fund: “More than in markets that move in one trend, volatile markets throw up arbitrage opportunities.” If expectations are bearish, the future trades lower than the stock. If expectations are bullish, the future trades at a premium.

When markets are continuously sliding, arbitrage funds (also called arbs) book profits in existing “cash and carry” arbitrages. Then, if the markets start going up again after a down move, taking fresh arbitrages are possible.

In the jargon, a “cash and carry trade” is when a stock (“cash” segment) trades lower than the future (“carry forward” segment)—that is, expectations are bullish. The arb buys the stock and sells the future to lock in a profit. A “reverse cash and carry” is when the future trades lower than the stock—usually in a bearish market (see How Arb Funds Benefit from Volatility). Then the arb sells the stock and buys the future. The profit is locked in by selling the future and buying back the stock close to expiry.

Reverse cash and carry involves short-selling if the arbitrageur doesn’t initially possess the stock to sell. In a short-sale, the seller borrows stock. Until recently, Securities and Exchange Board of India (Sebi) frowned on stock-lending, making it tough to exploit reverse cash and carry situations. Sebi has just given the green signal for institutions to carry out stock lending and short-selling. That creates a new channel for safe profits.

Arb funds must have fast reflexes in order to maximise gains. Sanjay Sinha, head of equities, SBI Mutual Fund, points out: “If you are the first to spot an arbitrage, you lock in the biggest spread. The spread reduces as more arbitrageurs enter.” By and large, arbitrage funds have delivered post-tax returns slightly in excess of fixed deposits (see table Arbitrage Funds). These speciality funds receive the same tax treatment as equity mutuals if at least 65% of assets are deployed in either equity or derivatives. A combination of volatile markets, benign tax regime and the stock-lending mechanisms could boost returns in future.