There has been a spate of derivative or arbitrage funds being launched, the most recent one being SBI Arbitrage Opportunities Fund. What is an arbitrage fund and what should investors look for before investing in one? The article addresses these and related issues.

But first a little background. Sometime back the markets were at an all time peak. And then the much feared correction arrived. Just when investors were almost giving up hope, the market turnedaround and crossed the 12000 mark again. In such volatile situations, what is an investor supposed to do?

Most astute investors book profits at regular intervals and milestones. And then when the valuations fall, they buy into bargains. Buy low and sell high is the only way to make money on the stock markets and those who actually do end up making the money follow this mantra regularly. (Also read - How to choose the right mutual fund)

Anyway, say you have sold some shares and booked profits. What will you do with the money? Some money can go back into stocks. But at this point you might not want to commit all your funds to equity. At the same time, you wouldn't want to lock up your funds for any length of time. You never know when the market will provide an opportunity next and you will like to keep your money reasonably liquid.

Income funds are not the answer. Interest rates being on the upswing investors would have to undertake a heavy "interest rate risk".

Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Therefore, in the past when interest rates were falling linearly year after year, most income funds yielded returns that even a well doing equity fund would be proud of. This is done by adjusting the portfolio to the market rate of returns is called 'Mark to market'. However, this article is not about the mechanics of the interest rate risk. (Also read - Low risk, high returns. Here's how)

In simple words, when interest rates in the economy rise, the NAV of an income fund falls and vice versa. Therefore, as of now, investors have to look elsewhere�some place that gives them fixed return at a very low risk.

Enter Arbitrage Funds

Investors not familiar with this type of scheme might just end up thinking that these are just equity-oriented schemes with another fancy name. However, this is not so. What such funds aim to do is to take advantage of the arbitrage opportunities between the cash and the futures market to generate fixed income. Therefore, these are a type of income scheme.

The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market.  Let's understand how this works. (Also read - How to build your MF portfolio?)

Suppose the stock price of XYZ Ltd. is quoting at Rs. 600. Let's say the stock is also traded in derivatives segment, where its future price is Rs. 610. In such a case, one can make a risk-free profit by selling a futures contract of XYZ Ltd. at Rs. 610 and buy an equivalent number of shares in the equity market at Rs. 600.

Now when settlement day arrives, it wouldn't matter which direction the stock price of XYZ Ltd. has taken in the interim. In other words, it is irrelevant whether the share price of XYZ Ltd. has risen or fallen, one would still make the same amount of money.

This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place --- buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, the investor earns the spread between the purchase price of the equity shares and the sale price of futures contract.

Examine the following table

In Scenario I, XYZ Ltd. skyrockets to Rs. 700 on the settlement date. At this point, the price will be same in the equity and futures markets. So when you sell the stock, a profit of Rs. 100 is earned. However, you also buy back the stock future thereby incurring a loss of Rs. 90. End result, a net profit of Rs. 10 is earned. The same thing happens even in Scenario II where the share price crashes to Rs. 500. Still you will end up with same profit.

Yes, it does sound like a very simple and effective way of making money in the market. After all, the problem that most investors have with entering into the equity market is the lack of assured risk free returns. And now here is a product that gives you exactly that. However, if only life were indeed that simple.

The first hurdle is the presence of arbitrage opportunities. In a given period of time, the market may or may not provide any meaningful arbitrage opportunities. And as explained above, it is these arbitrage opportunities that hold the key to the amount of money the fund will earn. No doubt, the fund management team will have to be extra vigilant in identifying such opportunities.

Of course, nowadays, they have sophisticated softwares that flag such mispricing the moment it occurs. However, investors do have to take into account the uncertainty of the supply of arbitrage as a hurdle in earning returns. For this very reason, such schemes cannot assure returns, the returns totally and completely depend upon available opportunity.

Secondly, there is the issue of costs. Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail the payment of these costs. Therefore, it again comes down to the presence of the arbitrage opportunity and it being meaningful enough i.e., after the payment of the expenses, the left over profit if any, should be material enough to make the transaction worth entering into.

To Conclude

Investors should note that by definition such schemes will always yield limited returns. However, the risk free nature of the returns is the USP of the product. Like mentioned earlier, if you want your funds to take a pit stop from the jet setting pace that the stock market has set, such a scheme will be an ideal shelter. Also, with the abolition of Sec. 80L, most fixed income earning avenues won't cover inflation post taxes.

However, in the case of non-equity MFs, dividends are subject to only a 14.025 per cent distribution tax, thereby again creating an arbitrage opportunity for taxpayers in the highest bracket. If one chooses the growth option and stays invested for over 1 year, capital gains tax @10 per cent or @20 per cent with indexation has to be paid.

This then becomes another alternative apart from Fixed Maturity Plans & Floating Rate schemes to beat the risks inherent in income schemes. Those wanting a breather from the equity market and those looking for safe fixed income should invest.

The author is the Director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be reached at sandeep.shanbhag@moneycontrol.com

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