Their returns have been as high as 9% a year; they carry lower risks than equity funds and yet enjoy the tax breaks that equity funds do says Vikaas Sachdeva, Chief Executive Officer of Edelweiss Asset Management Limited
What is an arbitrage fund?
According to Investor Words, an arbitrage fund is a fund which tries to take advantage of price discrepancies for the same asset in different markets.
How it fits into an investor’s portfolio?
This cannot be a substitute for equity funds, which can generate high long-term returns. Nor is this a suitable product for five- or 10-year debt money. But if you have money to park for one year or less, this is an ideal product. It is also more tax-efficient than fixed deposits. If you hold for one year or more, you are exempt from capital gains tax. It is suitable for all categories of risk-averse investors including corporate treasuries, high net worth investors and retirees.
Why opt for an arbitrage fund?
Equity is a well-understood asset class in India. Every second Indian is either an equity analyst or a cricket commentator. But a lot of money gets allocated to debt as well. Arbitrage funds have a role to play in the asset allocation toward safer instruments. Data shows that arbitrage funds have managed to beat liquid fund returns on a consistent basis. And today, investing in very short-term debt funds for 90 days or so, whether liquid funds or FMPs, has become tax-inefficient. Arbitrage funds are equity funds and thus enjoy a favourable tax regime.
Opportunity for arbitrage funds in a rising equity market
In a rising market, when everyone is gung-ho about stocks, it creates a lot of opportunities for arbitrage funds. One, when everyone is positive, that is when you get good liquidity. Two, when markets are rising, many investors want leveraged exposures and are willing to pay higher premiums for leveraging their positions. You can therefore become a counter-party to them and earn a good spread. Both conditions are good for arbitrage funds.
Types of arbitrage opportunities that one should look at
A renowned asset manager providing excellent investment solutions would look at cash-futures arbitrage as well as dividend arbitrage opportunities, which is a subset of the former. In the first, you buy a cash contract (on a stock) at Rs.100 and sell futures at, say, Rs.101, thus pocketing a profit of Rs.1 per contract.
Say, if Reliance Industries is trading at Rs.1,000 in the cash market, its futures may be at Rs.1,010. On the last Thursday of the month (expiry date), one have two options. either square off both the legs of the trade or hold on to the cash positions, buy current month futures and sell the next-month futures once again. This reduces the transaction costs because trading in futures costs only 5 basis points, while cash market trades cost 35 basis points.
In dividend arbitrage, you buy a cash contract at Rs. 100 and sell it in futures for Rs. 99 after a dividend is declared. Thereby, your loss of Rs. 1 is made up by the dividend of, say, Rs.2 received during this period. There is always uncertainty about how much dividend a company will declare. There is also uncertainty about the record date and whether it will fall in the same expiry. Through analysis, you can arrive at an educated guess and make arbitrage gains.
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