Hit the bull's eye all the time

Arbitrage funds offer modest returns and attract lower taxes. Replace the debt funds and fixed deposits in your portfolio with these low-risk funds.

Tanvi Varma/Money Today        Print Edition: December 13, 2007

The markets are still on a dizzying ride—up one day, down the next. Yes, the ups are more pronounced, but investors are nervous about relying too much on this. That’s why most investors are delighted at the prospect of lowrisk returns. And no, we are not talking fixed deposits or savings accounts—a relatively new breed of mutual funds offers around 9% returns. Plus, in most cases, there is no tax on long-term capital gains.

Arbitrage funds have strangely not caught the fancy of many investors, possibly because the word arbitrage does not evoke confidence. Arbitrage involves simultaneous purchase and sale of identical or equivalent instruments from two or more markets in order to benefit from a discrepancy in prices. The transactions offset each other, making the fund immune to market movements.

The profit is the difference in the prices of the instrument in different markets. “Arbitrage funds are also known as market neutral funds, since they do not have direct exposure to the equity market,” says Rajiv Anand, CIO, Standard Chartered Mutual Fund.

Still not sure what this means? Take the case of, say, Reliance Industries. On 14 November, Reliance Industries (RIL) shares closed at Rs 2,888 in the cash market; the November future closed at Rs 2,905. To cash in on the price differential of Rs 17, a fund can sell a future contract of 150 shares of RIL and buy an equal number of shares in the cash market.

Returns %
Arbitrage Schemes (Growth Plans) 
AUM in Rs Cr 
Benchmark Derivative Fund 
ICICI Pru Blended Plan -A 
ICICI Pru Blended Plan -B 
ICICI Pru Equity & Derivative Income Optimiser 
JM Arbitrage Advantage Fund 
JM Equity & Derivative Fund 
Kotak Equity Arbitrage 
Lotus India Arbitrage 
SBI Arbitrage Opportunities Fund 
Standard Chartered Arbitrage Fund 

Source: Valuesearchonline. Data as on November 14

On settlement day, the price of RIL shares and its future will coincide, when one should sell shares in the cash market and buy back the future contract. If RIL closes at Rs 2,700, the fund would make a loss in the cash market of Rs 28,200 (Rs 188 x 150 shares) and a profit of Rs 31,800 (Rs 212 x 150 shares) in the future contract, making a net gain of Rs 2,550 (Rs 17 x 150). If RIL closes at Rs 3,100, it would still make a profit of Rs 17 per share.

The risks. With only about 200 stocks permitted to trade in the derivatives market, it could get difficult to find enough arbitrage opportunities. Also, the buystock sell-future strategy will not work if the future price of the stock is at a discount to its spot price, which is common in a bearish phase.
Here's how arbitrage funds gain irrespective of the market swings. A fund sells a future contract (lot size of 1,000 shares) at Rs 210 and buys 1,000 shares in the cash market for Rs 205 per share.
Scenario I: Share price falls
Closing price of share on expiry Rs 200
Loss in cash position Rs 5,000 (Rs 5 x 1,000)
Profit in future position Rs 10,000 (Rs 10 x 1000)
Scenario II: Share price rises
Closing price of share on expiry Rs 210
Profit in cash position Rs 5,000 (Rs 5 x 1,000)
Profit/loss in future position Nil
Scenario III: Share price stays steady
Closing price of share on expiry Rs 205
Profit/loss in cash position Nil
Profit/loss in future position Rs 5,000 (Rs 5 x 1,000)
Irrespective of which way the market moves, the fund gains Rs 5,000 in all three situations.

“When it is difficult to spot arbitrage opportunities, we invest in low spreads,” says Vivek Pandey, fund manager, State Bank of India Mutual Fund. “The minimum and maximum returns by doing this is about 5% and 10%, respectively,” he adds. Another problem with regard to arbitrage funds is the lower liquidity in the spot/future segment. Future contracts are traded in lots; one lot of a future contract of a stock will have multiple shares.

For instance, company X may have a lot size of 50 shares, while company Y may have 10,000 shares. If an arbitrage opportunity arises in company Y, the fund manager will have to buy 10,000 shares from the stock market and sell one future contract. If the fund manager decides to sell, say, 30 lots, he has to buy 3,00,000 shares. The manager may not be able to buy the desired number of shares at the given price.

While some arbitrage funds can be liquidated on any day, others can be redeemed only on the settlement day. “Ideally, we advise investors to redeem on expiry day since one locks in to the return”, says Nilesh Shah, CIO, ICICI Prudential Mutual Fund.

Tax-efficient. These risks should not put you off arbitrage funds. Bank fixed deposits (FDs), fixed maturity plans or money market funds might provide higher returns, but are not tax-efficient. An FD that gives 9%, for instance, results in a post-tax yield of 6.3% (in the highest tax slab). In debt funds, long-term gains (over one year) are taxed at a flat rate of 10% or at 20% after indexation.

Arbitrage funds invest 65-80% of the corpus in equities and equity derivatives. So like equity funds, short term gains are taxed at 10% and long-term gains are tax free. Some funds also have debt options, where equity and derivatives investments are restricted to 45%. Their tax treatment is similar to that for debt funds.

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