Insights

FundsIndia Strategies: Arbitrage Funds

July 22, 2014 . Vidya Bala

In our weekly call last week, we discussed our debt strategy post budget. As a part of the strategy, we discussed about the investment opportunities in arbitrage funds and recommended three funds. This week, we’ll take a look at arbitrage funds, their strategy, whether they will suit you and our brief on three such funds.

What they are

Arbitrage funds take controlled exposure to equities. What do we mean by controlled exposure? They will simply carry out strategies which would have offsetting positions on various markets at the same time. In other words, the schemes take hedged positions that make them ‘market neutral’ or with no specific equity risk.

Arbitrage funds are open-ended equity schemes that will generate income through arbitrage opportunities arising out of mispricing across spot, futures and options market, leading to profits. They will also seek to invest some proportion in debt when warranted.

Such funds could take positions in stocks in the cash market (say buy) and an opposite position (sell) in the same stock in the derivatives market and vice versa. Similar strategy can be adopted on the index as well. These positions can be either squared off before expiry or rolled over.

Typically, volatile markets offer more arbitrage opportunities between the cash and derivative market. In the event of no adequate arbitrage opportunities, funds may choose to increase exposure to short-term debt and liquid instruments.

In all, this class of funds seek to provide you with money market plus returns. That they are treated as equity funds and hence, provide capital gains tax exemption if held for over a year makes them tax efficient short-to-medium term options. Being equity funds, they do not also suffer any dividend distribution tax.

Suitability

The first qualification to invest in these funds is that you understand how they work. Why is this so important? For two reasons: one, if you are looking for substitutes for debt funds these really are not debt funds although their risk profile may mimic low-risk debt.

Two, if you understood these funds as being equity funds, then you may wonder why they deliver low returns, when equity funds manage higher returns.

Hence, it is important to understand that arbitrage funds primarily use hedging strategies. In the process, if they generate some profit as a result of mis-pricing, you benefit more. Else you benefit about the same as you would with liquid or ultra short-term funds.

Besides understanding the thesis behind these funds, if you are looking at a time frame of 1-2 years and are primarily looking for tax efficient ways to invest in low-risk options, arbitrage funds can work for you.

Here are the funds we chose in this category:

SBI Arbitrage Opportunities – Of our picks, this fund would fare as our relatively low risk pick. The fund’s deviation from mean returns is very low. As of June 2014, well over a third of its assets were in commercial papers and fixed deposits; perhaps an indication that arbitrage opportunities were not high then. Still, a combination of hedging and debt holding has helped the fund deliver 8.5% absolute returns in just 6 months now.

The fund had close to 10% of its hedged equity assets in midcap stocks. This segment could possibly provide more mis-priced opportunities. Banks, cement and cement products and pharma were among the top sector exposures.

IDFC Arbitrage Fund – This fund would fare next in terms of low standard deviation and risk. At present it has about 70% of hedged exposure to equities and the rest in debt instruments – mostly certificates of deposits and other liquid instruments.

On a daily rolling return basis over the last 3 years, the fund generated an average 1-year return of 8.8%, while the maximum returns it managed over the same period was 9.7%. The sectors in which it has maximum hedged equity exposure include banks, pharma, cement, and oil and gas; weights being highest to the first-mentioned sector. The fund is also amongst the more consistent player in terms of beating the CRISIL Liquid fund Index over 70% of the times on a rolling – return basis.

table_arbitrage_july22

ICICI Pru Equity – Arbitrage Fund – This fund seeks to hold anywhere between 65-80% in hedged equities; it can hold unhedged equity of not more than 5% and is allowed to hold the rest in debt. The unhedged position is meant to allow liquidity instead of disturbing hedged positions. Still, to the extent of such position, its risk element is slightly enhanced. This is reflected in its higher standard deviation.

That said, the maximum one year returns it generated (in the last 3 years) is also higher than the above funds at 11.2%.

32 thoughts on “FundsIndia Strategies: Arbitrage Funds

  1. FMP’s and Debt funds were promoted for their tax efficiency and now FM has axed them. there are chances that in future Arbitrage funds are classified as debt funds? If market goes down from here then the furure prices will be lower than spot prices..how can a arbitrage fund make money in that event? they can’t short sell and buy futures. More arbitrage funds will kill the spreads for sure.

    1. Hello, It depends on the arbitrage strategy. One need not always go long on cash and sell futures. It can work the other way round too.Also, the idea in a falling market, is to prevent negative returns, not to always make arbitrage profit. These funds can also take reasonable exposure to debt. As for tax laws, what if equities were no longer given capital gains exemption in future? We have to live with that that uncertainty. thanks, Vidya

  2. Hi Vidya,

    Very timely article. I have a few liquid and ultra-short term mfs under two categories
    Dividend Re-investment to take care of my monthly STP to various equity funds
    Growth: for more than a year – 3 years investment. I may withdraw early based on my requirements.

    SHould i switch from current Growth liquid/ultra short mfs to these arbitrage funds? What is your advice?

    Regards,
    Anjani Singh

    1. Hi Anjani, it would depend on your idea behind holding this money. If you are holding liquid ultra short term to transfer to equity, then you could continue to have the STPs done with them. If you are simply holding them for 1-year plus term, then you can look at arbitrage funds but remember they are first hedging tools, only then tax efficient tools. If you are reasonably sure you will hold the current short-term debt funds for 3 years, then you might as well hold.

      In future, if you do not have a very large sum and are looking at equity with a 7-year plus perspective (and short-term falls won’t perturb you) then you could simply invest as lump sum in about 3 tranches in equity funds instead of even opting for an STP.

      thanks, Vidya

  3. Hi Vidya, there are 2 funds from ICICI Arbitrage & Blended (per VRO). So what is the difference between them?

    1. Sheetal, The blended Plan A is also arbitrage but given its eariler history of sometimes closing down for fresh inflows, we have not considered it. Also ICICI Pru Equity Arbitrage can take about 5C% unhedged exposure, making it easier to manage any liquidity issue. thanks, Vidya

  4. Hello,
    Thanks for very informative article.
    I have recently started investing in MF through FundIndia.com. I am investing in 2000 in ICICI blue chip and UTI opportunity fund. Now i want to increase my investment 3000 per month.also want to invest in one debt fund for short period but in this budget government has increase the tax on debt fund. Is it ok to invest in arbitrage fund ? If yes, which one is good. Please suggest me one balance fund as well
    Thanks in advance.

    1. Hello Satish,

      Thank you for writing to us. Investor queries are normally addressed using the Investor appointment feature (click help tab in your account). I have discussed your reqmt and one of our advisors will contact you to provide you with a suitable fund. thanks, Vidya

  5. Hi Vidya – Would appreciate your views on the post-budget treatment of Liquid Fund Dividend Reinvestment option? Excuse my naivete – but what I’m trying to understand is whether shifting from Liquid Fund Growth option to Liquid Fund Dividend Reinvest option will be more tax efficient?

    1. Hello Vivek,
      If you are going to withdraw the money on and off and in the 30% tax bracket, there is a marginal benefit in dividend reinvestment over growth (28.3% over 30.9%). But the hassle of having to calculate nay small capital gain under the dividend reinvestment option (if you are going to withdraw frequently) makes it not worth the trouble. Also, if you plan to do regular SWP, then growth is better. Vidya

  6. Hi Vidya ,

    I have a lump sum amount of 2.5 lacs and planning to invest in Arbitrage fund . Should i invest lump sum at one go in the arbitrage fund or invest all in a liquid fund and do STP to arbitrage fund . Please advise.

    thanks
    Saumyo

    1. Hello Sir, Arbitrage funds in general do not need any systematic deployment as they are low risk. Vidya

  7. Hi Vidya ,

    I have a lump sum amount of 2.5 lacs and planning to invest in Arbitrage fund . Should i invest lump sum at one go in the arbitrage fund or invest all in a liquid fund and do STP to arbitrage fund . Please advise.

    thanks
    Saumyo

  8. Hello vidya,

    Is there a possibility of arbitrage fund giving a negative return? if so under what scenarios it could return negative returns?

    Please advise.
    Thanks,
    Vinay

  9. Hello vidya,

    Is there a possibility of arbitrage fund giving a negative return? if so under what scenarios it could return negative returns?

    Please advise.
    Thanks,
    Vinay

  10. Hello Vidya,

    Is there a remote possibility of arbitrage fund to give negative return?Please confirm,.

    1. Sorry for the delayed response. If the strategy is 100% hedging – that is full arbitrage – then it should not. It some portion of the fund is unhedged (possible in arbitrage plus funds) it is possible.

    2. Hello Sir,
      Sorry for the delayed reply. In the Indian scenario, since arbitrage funds can only hedge against cash positions, they should not give negative returns. The negative return scenario is possible when the fund is not fully hedged (open equity cash positions) or has some exposure to debt, which suddenly falls. Thanks, Vidya

    1. Sorry for the delayed response. If the strategy is 100% hedging – that is full arbitrage – then it should not. It some portion of the fund is unhedged (possible in arbitrage plus funds) it is possible.

    2. Hello Sir,
      Sorry for the delayed reply. In the Indian scenario, since arbitrage funds can only hedge against cash positions, they should not give negative returns. The negative return scenario is possible when the fund is not fully hedged (open equity cash positions) or has some exposure to debt, which suddenly falls. Thanks, Vidya

  11. Hi Vidya, there are 2 funds from ICICI Arbitrage & Blended (per VRO). So what is the difference between them?

    1. Sheetal, The blended Plan A is also arbitrage but given its eariler history of sometimes closing down for fresh inflows, we have not considered it. Also ICICI Pru Equity Arbitrage can take about 5C% unhedged exposure, making it easier to manage any liquidity issue. thanks, Vidya

  12. Hi Vidya,

    Very timely article. I have a few liquid and ultra-short term mfs under two categories
    Dividend Re-investment to take care of my monthly STP to various equity funds
    Growth: for more than a year – 3 years investment. I may withdraw early based on my requirements.

    SHould i switch from current Growth liquid/ultra short mfs to these arbitrage funds? What is your advice?

    Regards,
    Anjani Singh

    1. Hi Anjani, it would depend on your idea behind holding this money. If you are holding liquid ultra short term to transfer to equity, then you could continue to have the STPs done with them. If you are simply holding them for 1-year plus term, then you can look at arbitrage funds but remember they are first hedging tools, only then tax efficient tools. If you are reasonably sure you will hold the current short-term debt funds for 3 years, then you might as well hold.

      In future, if you do not have a very large sum and are looking at equity with a 7-year plus perspective (and short-term falls won’t perturb you) then you could simply invest as lump sum in about 3 tranches in equity funds instead of even opting for an STP.

      thanks, Vidya

  13. FMP’s and Debt funds were promoted for their tax efficiency and now FM has axed them. there are chances that in future Arbitrage funds are classified as debt funds? If market goes down from here then the furure prices will be lower than spot prices..how can a arbitrage fund make money in that event? they can’t short sell and buy futures. More arbitrage funds will kill the spreads for sure.

    1. Hello, It depends on the arbitrage strategy. One need not always go long on cash and sell futures. It can work the other way round too.Also, the idea in a falling market, is to prevent negative returns, not to always make arbitrage profit. These funds can also take reasonable exposure to debt. As for tax laws, what if equities were no longer given capital gains exemption in future? We have to live with that that uncertainty. thanks, Vidya

  14. Hi Vidya – Would appreciate your views on the post-budget treatment of Liquid Fund Dividend Reinvestment option? Excuse my naivete – but what I’m trying to understand is whether shifting from Liquid Fund Growth option to Liquid Fund Dividend Reinvest option will be more tax efficient?

    1. Hello Vivek,
      If you are going to withdraw the money on and off and in the 30% tax bracket, there is a marginal benefit in dividend reinvestment over growth (28.3% over 30.9%). But the hassle of having to calculate nay small capital gain under the dividend reinvestment option (if you are going to withdraw frequently) makes it not worth the trouble. Also, if you plan to do regular SWP, then growth is better. Vidya

  15. Hello,
    Thanks for very informative article.
    I have recently started investing in MF through FundIndia.com. I am investing in 2000 in ICICI blue chip and UTI opportunity fund. Now i want to increase my investment 3000 per month.also want to invest in one debt fund for short period but in this budget government has increase the tax on debt fund. Is it ok to invest in arbitrage fund ? If yes, which one is good. Please suggest me one balance fund as well
    Thanks in advance.

    1. Hello Satish,

      Thank you for writing to us. Investor queries are normally addressed using the Investor appointment feature (click help tab in your account). I have discussed your reqmt and one of our advisors will contact you to provide you with a suitable fund. thanks, Vidya

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