Risk and return are directly linked. Risk-averse investors head for debt funds, which trade instruments with known but low returns. Some arbitrage funds try to boost returns without additional risk. An arbitrage is defined as the trading of the same asset in two markets or the trading of interchangeable, equivalent assets.
Logically you may wonder why the same asset is priced differently on two different exchanges. But in practice, this happens for many reasons. There may for instance, be a difference in supply-demand because one big player is operating in one market and not the other.
The arbitrageurs smoothen out differentials and score low-risk returns buying where the asset is cheap and selling where it's dear. The strategy is market-neutral the direction of market movement doesn't make a difference.
In the mid-1990s, interexchange arbitrage was popular. Settlement on NSE and BSE occurred on different days, and prices often differed significantly. By buying on NSE and selling on BSE, or vice-versa, arbitrageurs pocketed the difference. Rolling settlements has ended this.
The most popular form of arbitrage now exploits differences between futures and spot prices in the derivative and equity markets. There are safe arbitrage opportunities but it requires high capital outlays and sometimes, large equity holdings as well.
The margin on a futures position is roughly 10% of the lot value. This is between Rs 35,000 and Rs 50,000 for a given lot. In addition, you need to buy that same lot in the spot market-that is another Rs 3-5 lakh. In certain arbitrages, you must possess underlying stock, on the NSE, one buys Nifty futures on the SGX and sells them on NSE.
Secondly, consider an American Depository Receipt (ADR) where local shares can be converted into depository receipts to be traded on US stock exchanges. Say, the ADR price is at a discount to the underlying share. Then converting the ADR into the underlying shares results in a gain. If the ADR price is at premium, reconvert the underlying shares into depository receipts.
|The Major Arbitrage Funds|
|JM Arbit rage Advantage|
|JM Equity & Derivative|
|Kotak Cash Plus|
|Prudential ICICI Blended Plan A|
|Prudential ICICI Blended Plan B|
|SBI Arbitrage Opportunities|
|Standard Chartered Arbitrage|
Corporate actions like dividend announcements, mergers and buyback offers also offer arbitrage opportunities. Around dividend declaration time, the stock futures/options market can provide opportunities. Generally, stock prices decline by the dividend amount when a stock goes ex-dividend. If a buy-back is announced, there could be opportunities due to price differentials in buy-back price and traded price. When a merger, hive off, de-merger, occurs there may be price differential in the cash or derivative markets.
Profits are reduced by transaction costs like brokerage, DP charges and securities transaction tax. Earlier Sebi norms restricted funds from investing over 50% of corpus in derivatives. Assuming a hedge to stay risk-free, the exposure (spot plus futures) was capped at about 75%. The balance had to be invested in debt or money market instruments, with lower returns. Says Sinha: Investors could expect anywhere from 6.5% to 8% from arbitrage funds. This is a conservative estimate since many arb funds have delivered between 7% and 10% (see table above).
The new Sebi norms of June 2006 allow funds to invest up to 100% in derivatives, subject to an overall corpus limit. So it is better to invest in funds launched after June 2006. Some fund houses have launched new schemes. For instance, JM has launched JM Arbitrage Advantage and Benchmark has applied for Benchmark Derivative Plus.
Although arbitraging is market neutral, there are risks. Says Sinha: Spot-future arbitrage opportunities emerge only in directional markets. Secondly, futures are settled by squaring off, rather than through share delivery. A derivative fund banks on the cash and futuresprice converging. However, if on the contact expiry date, there is a mismatch between settlement price in the cash market and the futures market, it can go against the fund. Finally, given many arbitrage players, the return reduces. In that case, the first mover is also the biggest gainer.
Nevertheless, the risk-averse could use arbitrage funds as an improved variant of short-term debt or liquid funds. The tax treatment is generous arbitrage funds with an exposure to equity of over 65% of corpus are treated as equity funds. Says Sandeep Shanbhag, tax planner: Those wanting a breather from equity or looking to park money for safe fixed income, should invest in arbitrage funds.