Safe Harbour. Get the arb advantage

Fixed maturity plans and debt funds came into the spotlight after the Budget tax tweaks. Arbitrage funds too burst upon the scene for the same reason. L&T and Axis Mutual Funds, for instance, both launched arbitrage funds in July and August. The past few weeks saw arbitrage funds being rolled out from the JP Morgan and Kotak stables as well.

So, what’s special about arbitrage funds?

Arbitrage occurs when you gain from buying and selling the same security at different prices in different markets. Funds built on this theme look at two main mispricing opportunities.

One is in the form of price differentials in the same stock on the NSE and the BSE. For instance, ACC hit its 52-week high of ₹1,570 when it opened on the BSE on September 10. But on the NSE, the stock initially traded at ₹1,536 and hit the day’s high at ₹1,552. The stock closed at ₹1,532 on the NSE and ₹1,536 on the BSE. In fact, ACC’s 52-week NSE high was a week earlier than the BSE, at ₹1,564.

But opportunities like these are few and far in between. Instead, arbitrage funds focus on the cash and derivatives market for mispricing opportunities. This is the most common route. The fund executes offsetting or opposite strategies on a set of securities in different markets simultaneously.

So, where does mispricing come in from? A future contract’s price is bound to the underlying security’s spot price. Theoretically, the future price should be the spot price plus the carrying cost. Carrying cost is the cost of holding the futures contract for its duration − usually the interest rate less any dividends.

But sometimes, the theoretical futures and spot prices may not match the actual price perfectly, giving rise to an arbitrage opportunity. A fund can buy a security in the spot market and sell in the futures market when the futures price is more than what it theoretically should trade at. The opposite is possible too − sell in the spot market while buying in the futures market. Funds can take positions on the index too. Arbitrage funds normally aim at recouping the carrying cost.

Funds need to closely track the cash and derivative markets to spot the differences. “Such execution may involve an algorithm that ensures execution is taking place at the best possible difference in prices. This is superior to manual trade entry,” says Pranav Gokhale, Fund Manager, Religare Invesco Mutual Fund.

Most arbitrage funds take opposite positions on their entire portfolio, thus wholly hedging their positions. So the first factor going for arbitrage funds is that risk is cut sharply.

These funds neither rise like equities, nor fall like them. Arbitrage funds do not take a call on market direction. You do have ‘arbitrage-plus’ funds, which leave a part of their portfolio unhedged. But there are limits to how much of the position can be left so.

A portion of arbitrage funds’ portfolio can go into debt instruments too, especially since mispricing opportunities don’t always present themselves. SBI Arbitrage Opportunities fund, for example, can put 65 to 85 per cent of its portfolio into equities and the balance goes into debt.

The second factor is that they are equity-oriented funds. That means holdings beyond a year are tax-free because they are treated as long-term capital gains. Dividend distribution tax does not apply.

The low risk and tax advantage are why arbitrage funds are presented as an alternative to short-term debt funds for those seeking tax efficiency.

In the one-year period, arbitrage funds have averaged returns of 9.02 per cent. Liquid funds have clocked 8.96 per cent returns and short-term debt funds 9.9 per cent. Three-year returns for the same categories are 8.85, 8.92 and 8.91 per cent, respectively.

But arbitrage funds work well only in volatile markets as that’s when mispriced opportunities are most prevalent. So limit the portfolio exposure to these funds and use them as a portfolio hedge. Arbitrage funds can be used to house your short-term funds.