Are you among those who feel stressed with the ups and downs of Capital markets? But, what if you could make returns without betting on whether the market goes up or down – this is the core idea of arbitrage funds, a unique category often associated with lower-risk investing or short-term parking of funds.
In a special interview titled ‘Understanding Arbitrage Funds: A Smart Option for Volatile Markets’, Rukun Tarachandani, Executive Vice President & Fund Manager – Equity, PPFAS Mutual Fund spoke about what exactly these funds are, how do they work, and are they the right fit for your portfolio? Read on to know more.
How do arbitrage funds work?
Simply put, arbitrage is a strategy that leverages on pricing inefficiencies in different markets. “In a typical arbitrage transaction, what we do is we buy a stock in the cash market and, simultaneously, we sell the same stock in the futures market. Since you bought and sold the same stock, our position is completely hedged and the risk of the stock price movement is minimised,” he explained.
The return for an arbitrage fund is not derived from taking a directional view on the stock price, which means it does not matter if the market goes up or down. As Tarachandani puts it, “Your return comes from the cash price and the futures price converging on the expiry date.” This differential between the two prices is the profit captured by the fund. This unique mechanism makes arbitrage funds a fascinating alternative to traditional equity investments.
So, can we then say that since arbitrage funds are hedged, they are immune to market conditions? There are several factors that influence their performance and market volatility can actually prove to be a boon for these funds. “All else equal, yes, volatility does help arbitrage funds, because when markets are volatile, it would give more opportunities to the fund manager to take advantage of the differentials in the cash and futures market, because they would be higher during volatile markets,” he further explained.
Besides volatility, other factors like interest rates, market sentiment and the basic principles of supply and demand also play a crucial role. For instance, bullish market sentiment generally leads to higher arbitrage spreads, while bearish sentiment can weaken them. Similarly, the spreads tend to be lower if a large amount of capital is going after arbitrage opportunities.
How do they fare with other investments?
Arbitrage funds are a good option for short-term parking of funds. The other asset classes that feature in this category include fixed deposits and liquid funds. “Historically, arbitrage fund returns have been broadly similar to what liquid fund returns have been,” he said. However, a key distinction lies in their tax efficiency. “For investors in higher tax brackets, these (arbitrage funds) would be more tax efficient versus other cash management or other avenues for cash management,” he explains. This can prove to be a significant advantage for those in top tax brackets, as long-term capital gains from equity funds are taxed at a lower rate compared to debt funds or fixed deposits.
Despite the tax advantage, it is important to remember that arbitrage funds are a bit more volatile than liquid funds, especially when the investment is for short tenures. For this reason, Tarachandani advised investors to have a time horizon of at least three months, the longer the better as this allows the volatility to average out.
Who are they best suited for?
So, who should consider investing in arbitrage funds? According to Tarachandani, these funds are an ideal choice for investors in higher tax brackets who need to park their funds for a period of three months or more. Another useful application is for Systematic Transfer Plans (STPs). An investor can park their surplus funds in an arbitrage fund and then systematically transfer them to an equity fund of their choice.
Investors must also bear in mind that while arbitrage funds are low-risk, they are not risk-free. The primary risks stem from the very factors that influence their returns. The expansion or contraction of arbitrage spreads due to changes in interest rates, market sentiment and supply-demand dynamics can cause the fund’s Net Asset Value (NAV) to fluctuate.
Arbitrage funds typically invest 65-70 per cent of the money in arbitrage opportunities, and the remaining portion in debt securities. A fund manager could potentially take on higher duration or credit risk in this debt portion to generate higher returns. “An investor should do careful due diligence to ensure that they are not exposed to an undue duration risk or credit rate risk,” he said. This can be done by scrutinising the fund’s fact sheet to understand its debt investment strategy.
In conclusion, arbitrage funds offer a compelling blend of low-risk and tax efficiency, making them a valuable tool for savvy investors. “We believe that while investing in an Arbitrage Fund, the most important factor for an investor is the safety and liquidity of capital,” Tarachandani said.
Watch the full interview now:
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.