At a time when volatility in equity markets are turning stock investors off, there’s one class of mutual fund that is in fact benefitting from the current volatility swing — arbitrage funds. Sample this. In the last three calendar years, arbitrage funds have given average returns of 8.83%, 9.24% and 7.75% compared to 6.76%, 27.70% and -24.62% returns for the CNX Nifty, according to CRISIL Research.
So what makes arbitrage funds outperform key market indices?
An arbitrage fund takes advantage of stock mispricing in two ways — playing the difference between a stock price on the NSE and BSE exchanges in the spot market; benefitting from the difference in the stock price and the future price.
The first one is simple. The arbitrageur will simply evaluate the difference between price of a stock on the NSE and the BSE. For instance, if shares of Biocon were trading at Rs 489 on BSE and at 489.75 on the NSE on January 22, this presents an arbitrage opportunity for fund managers. He’ll buy the stock on the BSE and sell it on the NSE and the difference will be his profit.
In the case of the second strategy called cash-futures arbitrage, the arbitrageur would enter into a simultaneous buying of the stock in the spot market and selling in the futures market. Take for instance, the Aurobindo Pharma stock price on January 22 on the NSE. The spot price is Rs 441.80 per share while it is Rs 442.65 in the futures market for the January 30 expiry. The fund manager would buy the stock on spot market as well as enter into futures contract to sell the stock at Rs 442.65. On the date of expiry, the fund manager makes profit (85 paise per share, 442.65-441.80) by selling in the spot market and the futures contract expires on its own.
The basic idea behind the strategy is to profit from volatility of the stock price in the short term. The short-term price differentiation can happen due to several factors. For instance, a stock could turn volatile as the date of it going ex-dividend nears, the company has announced buyback or merger, there’s a stock split, or the company is about to announce its earnings results.
As Jiju Vidyadharan, Director, CRISIL Research, says, “Arbitrage funds seek to generate returns from the mispricing between cash and future markets. In times of equity market volatility, this mispricing tends to be higher and thus helps these funds generate higher returns compared to pure equity funds.”
Peripheral Advantage
Market volatility and price mismatches present a major investment opportunity for arbitrage fund managers to take advantage of. But does it mean arbitrage funds fetch better returns than equity fund or debt funds?
Arbitrage funds are more suited for investors with low risk profile seeking stable returns as risk involvement of these funds is less as compared to traditional funds, experts argue. However, that shouldn’t lead one to believe that they are always better than equity funds or debt funds, as the returns depend on how markets play out, they add.
If, for instance, market is moving in a single direction, whether up or down, this is little investment opportunity for fund managers to benefit from price mismatch and hence the performance of arbitrage funds could be lesser than equity or debt funds.
“The drawback of investing in arbitrage fund is that it will fetch normal returns even though market may give very good returns. Its returns may not follow the returns of the market. And the same thing acts as an advantage for the fund that even though the market may give negative returns during the year, arbitrage fund may not lose as much as the market,” maintains Vivek Gupta, Research Head, CapitalVia Global Research, a financial markets research company headquartered at Bangalore.
For the tax calculation, arbitrage funds are treated as equity funds, as their asset allocation is predominantly stocks (See Comparing Arbitrage Funds...).
“These funds offer tax benefits similar to equity funds, thereby improving the tax efficiency compared to short maturity debt funds of a similar risk profile. In comparison, short term debt funds may generate higher returns when short term rates are at a high,” says Vidyadharan of CRISIL Research, adding that in the last three calendar years, arbitrage funds have given average returns of 8.83%, 9.24% and 7.75% compared to 9.03%, 8.54% and 8.15% for CRISIL Liquifex (benchmark for liquid funds).
Growth Or Dividend
The advantage of arbitrage funds is that the higher the volatility is in the market the better it is for these funds to make profit. Experts therefore advise mutual fund investors to keep a portion of these funds in the overall portfolio of funds as a hedge against volatility and profit from it.
“While a core portfolio can be purely with the hopes of a bull market, a side of arbitrage fund would provide returns when the core portfolio is unsteady. The disadvantage is the potential underperformance in steady market conditions,” maintains Srikanth Meenakshi, co-founder and COO, FundsIndia.com.
However, when it comes to choosing between growth, dividend, equity or debt options of arbitrage funds, experts advise investors to consider their risk return profile, time horizon and cash flow requirement. For instance, as Vidyadharan maintains, investors who would want cash flows at intervals can go for dividend options. They should however, note that the frequency and quantum of dividends is not fixed and depends on the profitability of the mutual fund scheme. For investors with a medium term horizon, the growth option may be better suited.
Experts further caution investors to differentiate between pure arbitrage and arbitrage plus funds before investing in them. In the case of the former, the equity component is completely hedged while the latter can take unhedged positions and thus carry a higher risk, according to CRISIL Research.