Why Investment in Arbitrage Funds is Safer Bet?
We Indians prefer to stack away our surplus money in cash, either apprehending some future emergency or fearing that all will be lost if the amount is invested in some financial schemes. We can’t go beyond the bank savings account where the money earns flimsy interests, and if there’s no pressing need for cash, we invest the money in fixed deposits.
Liquid funds are a far better option to park your money to generate wealth in the short-term (usually from one month to a year). These are money market mutual funds that invest in term deposits, treasury bills, commercial papers and similar instruments. The main aim of a liquid fund is to provide investors the opportunity to earn returns, sans compromising the liquidity and safety of the investment.
But liquid funds, over the past few months, have yielded lower returns than a year back. Even with lower returns, a liquid fund is a much better instrument to park your cash rather than your savings bank account.
Today, let’s look into arbitrage funds that have emerged as a viable alternative to liquid funds to generate returns in the short-term.
What are arbitrage funds?
Arbitrage means the simultaneous buying and selling of currency, securities, or commodities in various markets, or in the form of derivatives, to take advantage of the difference in price of the same asset. Arbitrage funds are a niche category among mutual funds that takes advantage of the arbitrage opportunities between futures and the spot market. The mispricing of the cash and derivatives market is exploited. These funds trade in equities and equity derivatives but generate wealth like fixed income.
How do Arbitrage Funds work?
Before feeling euphoric about the returns, let’s first understand how an arbitrage fund works. Suppose the share price of XYZ Co Ltd in the cash or sport market today is ₹100 and that of the November futures contract in the futures and options (F&O) market is ₹110. Now, if you buy 1,000 shares of the company from the spot market and sell 1,000 in futures, you will pocket a profit of ₹10,000 today. On 26 November, when the futures contract expires, the price will converge with that of the cash market. here the expiry price doesn’t matter. You can still manage a net profit before factoring in other expenses. Let’s see how.
Suppose the expiry price is ₹120, which means your profit is ₹20 per share that you took delivery or bought from the cash market. In the futures market your loss will be ₹10 per share. So your net profit, before other expenses, would be ₹10,000 i.e. ₹10 per share for 1,000 shares. Now, what happens if the share price falls to ₹90 on the expiry date? For the shares you took delivery, your losses will be ₹10 per share. But you will still make ₹20 as profit in the futures market. Your net profit for 1,000 shares will again be ₹10,000. It’s almost a win-win situation where risk is minimal. But you have to spot correctly the arbitrage opportunity.
So if there’s a ₹1 difference between the cash and futures price, should you execute an arbitrage strategy to make a windfall? It’s not that simple. You have to consider the transactions costs. Both in the F&O and spot markets, you have to factor in service tax, securities transaction tax, brokerage, etc. Besides, you broker would require you to maintain a minimum margin to take out a futures contract. There’s also an opportunity cost to keep the margin. You can carry out an arbitrage trade only when the price difference in the futures and spot market is big enough to cover these costs. While the spot and futures price difference is one type of arbitrage opportunity, the same between the National Stock Exchange and the Bombay Stock Exchange is another one.
Benefits of Investing in Arbitrage Funds
Minimal risk is one of the biggest advantages of arbitrage funds. Since each security is bought and sold at the same time, there’s almost no risk associated with long-term investments. Besides, these funds invest partly in debt securities that are largely considered as stable. If there’s a shortage in profitable trades, the fund may invest heavily in debt, which makes them appealing to investors having a low-risk appetite.
Arbitrage funds are perhaps the only low-risk investment instruments that can flourish in volatile markets. Volatility causes uncertainty among investors. The difference between futures and cash market burgeons. Stable markets mean individuals share prices are not showing much change. Sans any clear bearish or bullish trends that may reverse or continue with the status of the market, investors won’t have reason to believe that equity prices over a one-month horizon will change drastically from the current levels.
Risk and volatility go hand in hand. You can’t pocket huge gains, or suffer big losses, without either. These funds are a great choice for risk-averse investors who want to reap the benefits of a volatile market, but with negligible risk.
Taxation of Arbitrage Funds
Arbitrage funds are classified as equity funds from the taxation perspective. Hence, they have the benefit of no taxes on long-term gains i.e. where the holding period is more than one year. For a lesser holding period, short-term capital gains are taxed at 15%.
The government, in contrast, has increased long-term capital gains tax on the debt-oriented funds from 10% to 20%. It has also changed the definition of “long-term” for debt funds from one year to 36 months, effective from 10 July, 2014.
Short-term capital from debt funds, are added to the income of an individual and taxed according to the tax slab.
Risks/caveats attached to Arbitrage Funds
Al this while, it may have appeared to you that arbitrage funds have no risk associated with them. However, that isn’t the case. Arbitrage funds are not entirely risk-free. Keep in mind the following points while investing in an arbitrage fund.
With a sharp spurt in demand (or growth of asset under management) for arbitrage funds, the opportunities may go down. An arbitrage fund can’t invest more than 35% in debt securities for retaining the tax treatment regarding equity funds.
An arbitrage fund may generate lower income than a debt fund. Lack of opportunities could be one of the reasons. Restriction on investments in securities, other than equities beyond a point, could be another reason.
Redeeming an arbitrage fund usually takes 3-5 days. So it’s not as liquid as liquid funds.
Some arbitrage funds may take an un-hedged equity exposure. For instance, the ICICI Prudential Equity Arbitrage fund, limits un-hedged exposure to 5% of the total portfolio. So the risk of such an exposure remains.
If you expect to benefit from a favourable interest rate movement, go for a long-term debt fund. Arbitrage funds are comparatively immune to such a movement.
Futures are traded in lots. For instance, Reliance and Infosys futures are traded in lot size of 500, while that of Ashok Leyland is 7,000. So for every Ashok Leyland lot the fund manager wants to sell in the futures market, he/she has to purchase 7,000 shares from the cash market. The fund manager, to take a more meaningful position, may end pushing up the spot price i.e. impact cost of a large trade, thereby lessening the arbitrage opportunity.
Three-year returns of Arbitrage Funds
Till 31 December, 2015, there was no major variation in return. Five-year returns for all funds ranged between 7.81% to 8.78% per annum and three-year returns were 7.81% to 8.69% per annum. The one-year return was between 7.01% to 8.39%. This was no surprise. Risk and reward always go together. Lower the risk, lower is the return potential.
Pre-tax returns of liquid funds were almost similar to that of arbitrage funds, with one-year returns being 6.05% to 8.36%. Three and five-year returns were 6.65% to 8.71%, and 6.79% to 9.18%, respectively. Post-tax returns could be skewed in favour of arbitrage funds because they get a better tax treatment.
It won’t be wise to compare between fund categories. But you’ll at least get an idea.
Who should invest?
As already said, arbitrage fund is a short-term money making instrument, for a period of more than a month and above. These funds don’t invest money in equity schemes, and neither do they take a directional bet in the equity market. They lock the difference in price between spot and futures at the same point of time. These funds are not for long-term wealth generation.
Arbitrage funds carry an exit load which usually ranges from 15 days to two months. Check the load before investing. These funds may mildly fluctuate in the short-term. Even a one-month return won’t look as attractive as a liquid fund or a short to ultra-short term fund. The monthly returns of an arbitrage fund are always volatile because of the monthly expiry at various spreads.
Arbitrage funds, in essence, are an alternative to liquid mutual funds. Returns are purely dependent upon the arbitrage opportunity available at a specific point of time. Use them as liquid investments and they shouldn’t be a major part of your portfolio.
These funds are usually suitable for investors in the 20% or 30% tax bracket. If you have an investment horizon of less than 12 months, go for the dividend option. An investor, who wants to remain invested for more than a year but less than three years, should ideally opt for the growth option. Investors with more than three years of investment horizon can go for the growth plan on liquid funds, fixed maturity plans or short-term funds.
Investors who enjoy short-term capital gains in the same year from investments other than equity funds or direct equities and who can wait for three and further six months from the date of investment, can go for the bonus option. The Association of Mutual Funds of India however, has recently issued a set of guidelines for asset management companies to check the bonus stripping practice. SEBI too raised concern declaring the bonus option as illegal. It called to avoid bonus striping plans to evade taxes. Many investors resorted to bonus stripping as a tax arbitrage.
There’s a belief among investors that arbitrage funds are all-weather funds because of the low risk. They are expected to perform both in the bull and bear markets. On the contrary, arbitrary funds perform well in volatile markets because the chance of mispricing is increased. During a bull run, equity investments in your portfolio stand to gain because futures are usually priced higher than cash. The fund manager will buy from the cash market and sell the futures thereby booking a risk-free return. But the fund faces a challenge in bear markets because then the stock would be priced higher than the future. It negates the arbitrage opportunity.
It’s advisable to park your money in arbitrage funds tactically, replacing some parts of your liquid and short-term debt funds, to earn better tax efficient returns in volatile and bullish markets.
Mymoneysage.in simplifies money management for you by aggregating all financial instruments at one place, On top of it you can also set your financial life goals and tag your investments to those goals, there is more to it, if you get stuck, somewhere u can also get unbiased advice from subject matter experts, but the best part is that it’s FREE….signup
About the Author:
Kishorkumar Balpalli – does not sing like his namesake but believes that financial literacy and discipline is the key to one’s financial freedom, kishor who is having over a decade of experience in financial services is the Founder & CEO of mymoneysage.in