Arbitrage Funds are open ended equity schemes that generate returns by taking advantage of the price differential from different markets, mainly from cash and derivative markets. These funds are basically hybrid in nature as they have the provision of investing a sizable portion of the portfolio in debt markets.
The fund has a low risk profile as it follows market neutral strategy i.e position in one market will be offset by the position in some other market.
Let’s understand how this works
Suppose company ABC Ltd on 15th Nov 2015 is quoting Rs. 3,000 in the cash market and its near term future contract which will expire on 27th Nov 2014 is trading at Rs. 3,015. Now in such a case the investor will sell futures contract at Rs. 3,015 and buy an equivalent number of shares in the cash market. By this investor will generate a profit of Rs. 15 in absolute term and holding period return of 0.5% and will wait for the contract to expire.
On the day of expiry the price of ABC Ltd in the cash market and in the derivative market will coincide. For instance the price on the day of contract expiry is Rs. 3,010. Now all needed by the investor is to reverse the initial transaction i.e. buy back the contract in the futures market and sell off the equity shares.
Now by selling equity shares investor has generated profit of Rs 10 and buying back the future contract has generated profit of Rs 5, which is equivalent to initial lock-in amount of Rs.15. This happens because on the day of expiry (settlement date) the price of the equity shares and their stock futures coincides.
On an annualised basis the return generated in the above illustration is equivalent to 16.42% which is higher than the money market yield currently at 8.3%. The return generated depends on the arbitrage opportunities available and is also subjected to cost associated with the transaction.
The biggest risk associated is the lack of arbitrage opportunities. The market with due course of time may or may not provide any meaningful arbitrage opportunities and fund performance is directly linked to the arbitrage opportunities captured. The fund manager needs to be extra vigilant in identifying such opportunities.
Second risk associated is the cost factor as it will define whether the arbitrage opportunity available is worth executing or not. Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail the payment of these costs.
Whom it suits
With technological innovations at stock exchanges, it has become easier for fund managers to track arbitrage opportunities. However, due to these innovations, the price differential between spot and derivative segment vanishes very quickly. This has substantially reduced the return these days and returns remain in single digits. Therefore, it is more suited for investors looking for low risk, low return.
The fund is primarily equity oriented so the tax treatment is same as that of other equity funds. Dividend will be tax free in the hand of the investors and capital gain tax depends on the investment time horizon. If gains are realised by the investor before 12 months, they will have to pay short term capital gain tax whereas if gains are realised after 12 months it will be tax free.