Arbitrage funds demystified – The Hindu

Arbitrage (arb) funds are positioned to take advantage of the mispricing in futures contracts. The average annual return on such funds is 6.5%. Most investors compare arb funds with bank fixed deposits and conclude that the former may not be a meaningful investment. In this article, we show why it is optimal to compare a combination of an arb fund and a passive fund (ETF or index fund) with an active fund on the same benchmark as the passive fund.

Alpha returns

Active funds are mandated to generate alpha returns. This refers to the excess returns that a fund generates over its appropriate benchmark. Average fees of large-cap active funds are about 1% fees, for index funds about 0.25% and for ETFs less than 0.10%. Active funds charge higher fees for the alpha returns they strive to generate. Note that active funds generate returns that is a combination of market (benchmark) returns and alpha. Empirical evidence suggests that more than 85% of the returns from an active fund can be attributed to the movements in its benchmark index. The higher fee is charged on the entire portfolio including the benchmark return, not just on the alpha component. Not that you can capture the benchmark return through a cheaper passive product.

In other words, you have two ways of generating active returns. You can buy an active fund. Or you can buy an ETF benchmarked to the same index and combine it with an arb fund. The ETF will generate market returns and the arb fund can generate the alpha. Note that arb funds are positioned to exploit any mispricing between futures and its underlying asset. So, arb funds may not necessarily generate alpha from the same benchmark as the active fund. Nonetheless, you would have created your own active fund by combining a passive product and an arb fund.

Bank deposits are exposed to credit risk but have no market risk. Arb funds do not have credit risk. They have typically low market risk, as they are structured to generate returns regardless of the market direction. The issue is that arbitrage opportunities may not always be available. Importantly, funds must be quick to capture such opportunities. So, arb funds may be unable to continually capture such returns. When arbitrage opportunities are unavailable, such funds may have to invest in money market instruments (treasury bills), earning lower returns.

(The author offers training programmes for individuals to manage their personal investments)