ALTERNATIVES TO DEBT - ARBITRAGE FUNDS

At a time when equity funds are losing out significantly in performance rankings, arbitrage funds appear to be back into reckoning and with good reason.

These funds have returned in the range of 6.5-9.7 per cent over the year, outpacing both the Sensex and equity diversified category by a huge margin.

But how did these funds manage this feat? What are the risk-return elements associated with arbitrage funds and who should invest in them?

Brass tacks


Arbitrage funds draw mileage from the momentary mis-pricing between stocks, in the cash and derivatives markets.

In other words, these funds play on the price differential between stocks and their futures and use that to lock in specific returns. For instance, consider this arbitrage opportunity in Strides Arcolab.

On February 4, the stock price closed at Rs 66.75, whereas its February futures closed at Rs 70.6.

Arbitrage funds would use such price differentials to sell the stock futures, while simultaneously purchasing an equal number in the cash market. And by doing so, they lock in the price difference minus the cost of transactions as profits.

So, regardless of the price at which the stock closes on the expiry of the Feb futures contract, the fund would have locked in the price differential as its profit.

This may explain how these funds managed to return positively despite their equity exposure when the diversified equity category lost value.

While the same is possible even if the stock price quotes at a premium to the futures price (reverse arbitrage), it is yet to take off in full swing, as it would then involve selling the stock short in the cash market.

Essentially market-neutral, the average returns recorded by these funds are a function of the number and profit potential of the arbitrage opportunities that come their way. And since, there aren’t as many of them, the average return of these funds is moderate and close to that of the money market.

This means these funds may return similarly during both bull and bear markets.

Risk-return payoffs


However, note that besides the availability of arbitrage opportunities, their returns are subject to the trades’ execution (high expense ratio), liquidity in the cash and futures segments of the stocks and, of course, the fund manager’s ability to spot such opportunities.

Since arbitrage funds enjoy a risk profile akin to that of debt funds or fixed deposits (which is why their returns are benchmarked against that of the money market), investors looking for low-risk investment avenues can consider allocating a portion of their funds parked in debt or fixed deposits in arbitrage funds.