A misperception about mutual funds among many retail investors, especially less experienced investors is that, these are risky investments. You should know there are several types of low risk mutual fund schemes where you can deploy your money productively (higher rate of return) instead of keeping it idle in your savings bank account. These schemes offer high liquidity and a reasonable degree of capital safety. Overnight funds, liquid funds, ultra-short duration funds and arbitrage funds are the lowest risk mutual fund products. In this blog post we will discuss about arbitrage funds, how they work, their advantages and disadvantages versus other low risk mutual fund schemes.
What are arbitrage funds?
Arbitrage funds are hybrid mutual fund schemes which aim to generate risk free profits by exploiting price differences of the same underlying asset in different capital markets. In financial parlance the term arbitrage denotes risk-free profits. These mutual fund schemes have a low risk profile and their returns generally reflect short term post tax money market yields. These funds are treated as equity or equity oriented funds from a taxation standpoint.
How do arbitrage funds work?
The most common arbitrage strategy is to exploit the price difference of an underlying security (or index) in the cash and derivative segments of the stock market. Let us assume that a stock is trading at Rs 100 in the cash market and for Rs 102 in the F&O (derivatives) market. You can lock in risk free profits by simultaneously buying shares of the stock in cash market and selling same number of futures in the F&O market. On expiry of futures, last Thursday of the month (depending on the F&O series), the cash (spot) price and futures price will converge. This strategy is totally market neutral as explained below.
On expiry of the futures the market value of your long (cash) and short (futures) position will be equal in value irrespective of the direction (up or down) of price movement since the initiation of the trades. Let us assume on expiry of your futures, the settlement price is Rs 105. You will make a profit of Rs 5 / share in the cash market and a loss of Rs 3 / share in the F&O market – your profit will be Rs 2 / share. If the settlement price is Rs 98, then you will make a loss of Rs 2 / share in cash market and a profit of Rs 4 / share in F&O market – your profit will again be Rs 2 / share. Please note that, fund managers may not wait till expiry to square off their trades. They may square off before expiry depending on the price difference and profit making opportunity.
Arbitrage funds versus other low risk funds
We will compare arbitrage funds with other low risk funds on 4 parameters.
- Capital safety: Arbitrage funds offer one of the highest degrees of capital safety compared to several other low risk funds because these funds have no credit risk. Liquid funds and ultra-short duration funds invest in securities which have credit risk. As per SEBI regulation put in place earlier this year, liquid funds and ultra-short duration funds have to mark to market prices of securities. If the credit rating of a security gets downgraded, then the price of the security will fall irrespective of the residual maturity of the security. We saw NAVs of several liquid funds falling, when the credit ratings of their underlying securities were downgraded or when the issuer defaulted. Arbitrage funds and overnight funds have no credit risk. While overnight funds are the safest investment options, arbitrage funds also offer high degree of safety provided you have investment tenures of 3 to 6 months or longer.
- Volatility: Though arbitrage funds follow market neutral strategy, these funds can be volatile in the very short term (prior to expiry of futures). Depending on the futures series (current, next month or next to next month), futures premium (difference between futures price and cash price) may expand or shrink or even turn into a discount depending on market conditions. However as explained earlier, arbitrage is market neutral over the entire tenure of the trading strategy. The chart below shows the volatility (standard deviation) of monthly returns of liquid, ultra-short duration and arbitrage funds over the last 3 years. The chart below that arbitrage funds are more volatile than liquid funds, but are usually less volatile than ultra-short duration funds.
Source: Advisorkhoj Research
- Liquidity (for investors): Redemption proceeds for debt fund units are paid out (credited to your bank account) in 1 – 2 business days, while that of equity oriented funds (including arbitrage funds) are paid out in 3 – 5 business days. Overnight, liquid and ultra-short duration redemptions are usually processed in 1 business day. Exit loads (charge for redemptions before a specified period depending on the scheme) differs from scheme to scheme even within the same category. Overnight funds and liquid funds have no exit load; arbitrage and ultra-short duration scheme can charge exit loads for redemptions within 1 week or month from the investment date. Overnight and liquid funds offer the highest liquidity to investors but if you have investment tenures of 3 – 6 months or longer then arbitrage funds also offer fairly high liquidity.
- Taxation: Arbitrage funds are much more tax efficient than overnight, liquid and ultra-short duration funds. Capital gains in debt funds (like overnight, liquid and ultra-short duration) held for less than 3 years are taxed as per the income tax rate of the investor. On the other hand, capital gains in arbitrage funds held for less than a year are taxed at 15%. If your arbitrage fund investment is held for more than a year, then profits of up to Rs 1 lakh in a financial year are tax exempt; profits exceeding Rs 1 lakh will be taxed at 10%.
- Returns: The chart below shows last 1 year (ending 9th October 2019) returns of overnight, arbitrage and ultra-short duration funds. You can see that arbitrage funds outperformed overnight funds. Even though arbitrage funds underperformed liquid funds on a pre-tax basis, it would have outperformed slightly on a post-tax basis for investors in the highest (30%) tax bracket even for investments held for less than a year. For investment tenures of more than a year, arbitrage funds would have clearly outperformed by a substantial margin for investors in the highest tax bracket. Your tax situation should be an important consideration when making investment decisions.
Source: Advisorkhoj Research
Principal Arbitrage Fund
Principal Arbitrage Fund was launched about 3 years back. The fund invests predominantly in equity and equity related securities with the aim of making risk free profits by exploiting price differences in the same underlying security / securities in different capital market segments. The objective of the fund is to earn stable income for investors and at the same time, ensure capital preservation for the investor by minimizing risks. The scheme has given nearly 0.3% returns in the last 1 month.
The fund seeks to invest in securities in the cash and derivatives (F&O) segment of the market with the aim of earning risk free profits. More than 75% of the portfolio assets are currently invested in equity or equity related securities to earn risk free profits in the short term. The balance portfolio is held in cash or invested in money market securities to earn income with low risk. The fund manager wants to get stable and tax efficient returns for investors in the short term.
In this blog post, we discussed about arbitrage funds, its pros and cons versus other low risk mutual funds like overnight funds, liquid funds and ultra-short duration funds. You should weigh pros and cons, in relation to your investment needs and risk appetite to make informed investment decisions.
You should consult with your financial advisor, if arbitrage funds (including principal arbitrage fund) are suitable for your investment needs.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.