Benefits of Arbitrage Funds

We should focus on MF attributes and eventually decide how to create a mutual fund portfolio. I made a quick recall that we haven’t looked at ‘Arbitrage Funds’ yet, the trendy investment option these days. So, I’ll keep this section brief, look into the Arbitrage fund and continue.

Before we comprehend ‘Arbitrage Fund’, it is essential to understand what ‘Arbitrage’ entails. If you are a frequent Varsity reader, then this is something you should be aware of. We have nudged on arbitrage in the past, illustrating calendar spreads, pair trading and put-call parity.

For those new to ‘Arbitrage’, here is a brief summary.

At some stage, we all have done an arbitrage deal. For instance, when I was in my first year of college,I got my cousin in Singapore to get me Rock n Roll audio tapes for Rs.100 and I sold them here in Bangalore for Rs.150 each; people were willing to purchase these tapes at that price, since there was no other option available.

The above is an arbitrage transaction.

In an arbitrage transaction, an asset like the audiotape is bought from a market such as Singapore at a lower price of Rs.100/- and sold in another market, such as Bangalore, at a higher rate of Rs.150/-. In this example, the arbitrageur can make a risk-free gain of Rs.50/-.

Contemplating this, arbitrage is truly attractive, is it not? If the aforementioned fact were to remain true, I could simply acquire cassettes in Singapore and resell them in Bangalore. Accomplishing this with significant amounts, would yield a tremendous amount of money.

But if only life was that easy 🙂

It is assumed that both markets have ongoing supply and demand. Let’s consider a situation where I purchase tapes worth Rs.100,000/- with the expectation to sell them for Rs.150,000/-; then suddenly realise that Rock n Roll is no longer popular in Bangalore and only Boyzone is in vogue! In this case, my investment would be at risk.

It’s clear that arbitrage is not as risk-free as often claimed. To illustrate this point, we examined the supply-demand risk linked to an arbitrage opportunity.

But it is not just that.

Imagine a case where one of my friends finds out about my plan, and tries to outdo me by purchasing tapes from Singapore for Rs.100 and selling them for Rs.140, so he can keep the upper hand.

Do you have any idea what would come next? A price war would erupt. I’d suggest a cost of 135, to which he might reduce to 125, and so on until all the profits are gone.

It is clear that when more people seek to take advantage of the same arbitrage opportunity, it diminishes the potential for arbitrage profits.

Now, think about the stock markets. Take a look at the snapshot below –

Kirloskar Industries is currently trading at 562.4 per share on the National Stock Exchange, and 546.40 on the Bombay Stock Exchange — a variance of 16 Rupees.

This is an arbitrage chance that entails buying Kirloskar Industries on the BSE at 546.4 and simultaneously selling it on the NSE for a slightly higher price of 562.4. The fact that the same security can be bought and sold at two different prices in two distinct markets presents this enticing investment opportunity.

If this transaction is properly carried out, one can expect a net return of around 16 Rupees.

The Arbitrage Fund is a mutual fund scheme that focuses its management on arbitrage opportunities available in the market.

 – The  Arbitrage Fund

In the preceding section, we examined one form of arbitrage opportunity; however, there are in fact multiple variations available on the market.

Mutual funds often search for attractive arbitrage opportunities, such as Spot-Future arbitrage. This type of arbitrage occurs when the futures trade at a price which differs considerably from its fair value in comparison to its underlying.

At any given moment, the fund may have either a long or short position on a stock in either the equity or futures market.

Could the above line leave you mystified? Allow me to explain in more detail what exactly occurs when it comes to an Arbitrage Fund. Have a gander at the corresponding snapshot beneath –

As of today, 18th June 2020, the stock price of Maruti stands at Rs.5,714.4/- per share, whilst its future is currently at Rs.5,735.6/-.

The difference between cash and futures is –

5,735.6 – 5,714.4

= 21.2

The distinction between cash and futures is the spread or basis. An arbitrage can be established to take advantage of this gap. This involves buying the asset in the lower priced market and selling it in the more expensive one – a simple strategy to remember.

Buy Maruti @ 5714.4 in the cash market

Sell Maruti Futures (Exping in June)@ 5735.6

It is essential to carry out the transaction indicated above simultaneously. Doing so will secure the spread, rendering it irrelevant where Maruti trades since it is certain you’ll acquire a spread of 21.6.

At expiry, Maruti’s stock price in both cash and futures will become the same. This is referred to as ‘Cash-Futures Convergence’. As such, this trade must be terminated or evened out on expiry day.

For example, assume on the expiry day, Maruti trades at 5780 in both the cash and futures market. The P&L is as follows –

Cash market trade

Buy @ 5714.4

Sell @ 5780.

P&L =5780 – 5714.4

= + 65.6

Here you make a profit of 65.6.

Futures market trade –

Sell @ 5735.6

Buy @ 5780

P&L =5735.6- 5780

= -44.4

Here you make a loss of 44.4.

So, on the one hand, you make a profit of 65.6, and on the other, you lose 44.4, but overall you make 21.2, i.e. 65.6 – 44.4.

The aim is to keep the spread secured. No matter what occurs, this should be your approach. It would be advisable to calculate at few other cost levels and observe the results.

Of course, there are other technicalities like rollover, transaction costs and execution risk. But it’s not necessary to delve into these details. It is important to have an understanding of what arbitrage is and how a fund involving this strategy operates.

Have a look at the following; this is an extract of the investment objective of DSP’s Arbitrage fund –

It’s evident that these funds aim to produce income via the cash and derivatives markets without going into depth concerning their exact tactics. Additionally, some may refer to their forecasts as providing ‘low volatility returns’.

A pure arbitrage trade like spot-futures arbitrage is generally low risk and it has a predetermined outcome, thereby making it typically less volatile.

Do not believe everything you hear. It is true that if the fund maintains an exclusive focus on arbitrage strategies, the expected low volatility would be accurate; however, it is important to look at SEBI’s precise definition of an Arbitrage Fund before drawing any conclusions.

An Arbitrage fund typically has a minimum of 65% of the funds allocated to Arbitrage strategies but are, in theory, free to do what they like with the remaining 35%. This leftover amount is commonly invested in debt funds and because of duration restrictions, it requires careful management to secure the highest yield possible. Although it may be less risky than some other investment vehicles, an Arbitrage Fund does still come with some volatility.

Take a peek at ICICI Pru’s portfolio of Arbitrage funds.

Nearly two-thirds of the exposures are arbitrage positions, with the remaining third in debt and cash. Every equity position is balanced by its futures to help maintain a risk-free balance.

Debt papers can lead to risk in arbitrage funds. How much? Consider this:

It appears that the Principal Arbitrage Fund had a heavily invested position in DHFL bonds, which unfortunately resulted in a default in October 2018. This led to the fund losing value, as the NAV dropped from 11.5 to 10.9, making for a decrease of 5.22%.

Admittedly, the 5.22% loss was not overly damaging; however, it took an exhaustive 1.5 year period to retrieve it and return the NAV to its original 11.5 value.

This chart teaches us three lessons about the Arbitrage fund –

• Many investors do not view Arbitrage funds as risk-free. This is due to the fact that they contain a debt component which can increase their level of risk.
• Risks can erase the returns that typically range around 5-7%, in the blink of an eye.
• Making an investment in an arbitrage fund requires a long-term view since it takes time to realise any returns.

I hope I haven’t detered you from investing in an Arbitrage fund!

The positive aspect of investing in an arbitrage fund is that it has the characteristics of a debt fund, but it is taxed like an equity fund. For more information on mutual fund taxation, we have included a chapter devoted to this subject (very generally speaking).

• Gains realised from equity funds that have been sold within a 12-month period are categorised as short term capital gains, with a 15% taxation rate applied.
• After having held on to Equity funds for over 12 months, a long-term capital gain is taxed at 10%s, with Rs.1,00,000/- exempted from the same.
• If an investor holds debt funds for less than 36 months, any gains generated are classified as short-term capital gains and will be taxed according to the individual’s income tax bracket.
• If debt funds are held for more than 36 months, the gains can be treated as long term capital gains and taxation of such returns will be 20% after indexation.

From a tax standpoint, I believe that taking on some risk could be beneficial; using an Arbitrage fund as an alternative to a low duration or short duration fund is one option. Both funds have similar reward and risk profiles.

I should point out that the advantage of an arbitrage fund lies mainly in its tax arbitrage characteristic, meaning it functions like a debt fund but is taxed as an equity fund.

Finally, in your search for an arbitrage fund, carefully examine the debt component of the portfolio. Be sure there are no excessively large positions and all instruments meet the requirements of a suitable investment.

It is essential to ensure that the arbitrage fund is not carrying any unhedged equity exposure since this would be counter-productive.