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Make Volatility Work: The Mechanics of Arbitrage Funds

Prableen Bajpai | 17 Feb, 2012  | Follow Author | Add to my Favourites 


In times when words such as volatile, choppy and uncertain start describing the stock markets, most of the investors become wary. On such occasions, the ‘unpredictable element’ of the markets is on the high and there is no clear sense of the direction which they indicate. This causes investors with ‘low to moderate risk appetite’ to feel jittery and nervous who usually prefer to wait for the rough weather to settle. But rather than waiting in the sidelines, there is a class of funds which can be picked! These are the ‘arbitrage funds’ which are best suited for a time when there is confusion and chaos about the market behaviour. These funds have a history of performing well in uncertain market conditions and volatility is something arbitrage funds not only withstand but actually thrive on.

In financial terms, Arbitrage is a strategy that consists of concurrent buying and selling of equal or comparable securities from at least two markets in order to profit from the variation in their prices. There are many market participants who identify arbitrage opportunities across asset classes and across markets, they are called arbitrageurs. Arbitrage funds work on the same principle and basically try and cash on the price variation of the same security in different markets. In this way, they lock the return (which is the difference in the price) at the time of the trade. This type of investment strategy makes arbitrage funds market neutral as they reverse the position at expiry of future contract. Hence, it ensures that the returns do not tread into negative terrain.

Mechanism
Arbitraging is a simultaneous purchase and sale of similar assets in different markets to take advantage of price discrepancy. These funds capitalise on the stock’s price difference between the spot market (cash segment) and the derivatives market (futures segment). This discrepancy in prices arises because the volatility in the markets gives rise to various speculations about the stock’s price in the coming days. For instance, if the price in the futures market is higher, then the stock can be bought in the cash market and simultaneously sold in the futures market to lock in a profit. The profit from an arbitrage transaction is known when the transaction is entered into and realized when the positions are squared off at expiry. An arbitrage is profitable only if the price difference is greater than the costs of making the deals.

Suppose the stock price of PQR Ltd. is quoting at Rs. 500. Let's say the stock is also traded in derivatives segment, where its future price is Rs. 510. In such a case, one can make a risk-free profit by selling a futures contract of PQR Ltd. at Rs. 510 and buy an equivalent number of shares in the equity market at Rs. 500. Thus the strategy will be to Buy PQR shares and Sell PQR futures. Now after waiting for the contract expiration period, on the settlement day, it is obvious that the future and the cash price tend to converge. At this time, the arbitrager will reverse the position i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place - buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price movement, the investor the same amount of money from the transaction.

On Expiration (Reversal of Positions)

Situation I

Situation II

PQR Price at Settlement

600

400

Profit/Loss on Sale of Equity Shares at Expiry

100

-100

Profit/Loss on Purchase of Stock Future at Expiry

-90

110

Net Profit

10

10


In Situation I, PQR Ltd. share price shoot-up to Rs. 600 on the settlement date. At this point, the price will be same in the equity and futures markets. So when you sell the stock, a profit of Rs. 100 is earned. However, you also buy back the stock future thereby incurring a loss of Rs. 90. End result, a net profit of Rs. 10 is earned. The same thing happens even in Situation II where the share price crashes to Rs. 400. Still you will end up with same profit.

Though ideally, the spot price should be such that it clearly has a futures price that reflects the holding period and the interest rates in the market place (there are other parameters as well). But many a times, there is a difference and the arbitrager takes advantage of these ‘mispricing’ to make a ‘risk-free’ return.

Advantages
- Arbitrage funds enjoy an edge over debt funds mainly because of the tax benefit. Long-term capital gains on debt funds are taxable at 10% without indexation or 20% with indexation (depending on which option is lower). Assuming that returns from arbitrage funds are the same as debt funds or even if arbitrage funds offer a slightly lower return, the tax advantage gives arbitrage funds a significant edge over their debt fund counterparts.

- No tax on the gains of arbitrage funds in the long term (one year or more) and only 15% tax in short term (less than a year). The mandatory 65% in equity needs to be maintained by the fund manager otherwise they would not qualify for the equity tax benefits.

-The returns are expected to be higher than the other comparable alternate investments.

- There is no price and leverage risk as the cash positions are completely hedged with futures, thus insulated by market volatility in the market.

The ‘Hidden’ Risks
- Arbitrage funds depend heavily on the availability of arbitrage opportunities in the market. In a given period of time, the market may or may not provide any meaningful arbitrage opportunities. Since, it is the availability of arbitrage opportunities that hold the key to the amount of money the fund will earn, lack of such opportunities can sometimes dampen the results.

- The issue with respect to cost cannot be ignored. Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs can chop some of the earnings. Therefore, it’s just not the presence of the arbitrage opportunity and it is also about it being meaningful enough i.e., after the payment of the expenses, the left over profit if any, should be material enough to make the transaction worth entering into. The catch is that these funds would work well only if spreads are significant.

- These funds do well only in limited circumstances.

- Arbitrage funds get impacted by lower liquidity in the spot and future segments.

Performance
The table below shows the returns of arbitrage funds over the short as well as the long run. Though the returns at places are negligible but haven’t turned negative even at one occasion.

Scheme Name

Absolute Returns

Compound Annualized

1 Month

2 Months

3 Months

6 Months

1 Year

2 Years

3 Years

UTI Spread Fund

0.74

1.33

1.99

4.08

8.46

6.83

6.52

Reliance Arbitrage Advantage Fund

0.63

1.07

1.97

3.39

8.08

NA

NA

IDFC Arbitrage Fund - Plan A

0.78

1.45

2.16

3.69

7.82

7.01

5.75

Kotak Equity Arbitrage Fund

0.78

1.60

2.27

3.49

7.67

7.25

6.39

JM Arbitrage Advantage Fund

0.76

1.41

2.23

3.58

7.64

6.94

5.99

HDFC Arbitrage Fund

0.88

1.31

2.22

3.53

7.46

7.24

6.18

ICICI Prudential Blended Plan  - Option A

0.64

1.09

2.04

3.07

7.03

7.24

5.88

ICICI Prudential Equity & Derivatives Fund - I O

0.70

1.06

1.92

2.94

6.92

7.27

6.08

Birla Sun Life Enhanced Arbitrage Fund

0.51

0.68

1.45

2.58

6.74

6.39

NA

IDFC Arbitrage Plus Fund - Plan B

0.73

1.39

2.07

3.31

6.73

6.55

5.52

IDFC Arbitrage Plus Fund - Plan A

0.71

1.35

2.01

3.18

6.46

6.29

5.26

Goldman Sachs Derivative Fund

0.70

1.09

1.82

2.79

6.33

5.69

4.84

Goldman Sachs Equity & Derivative Opportunities

0.70

1.15

1.88

2.81

6.33

6.09

5.22

The schemes are in order based on one year returns. Returns as on February 16, 2012. Growth option considered

Make Volatility Work 
An investor can consider including these funds in his core portfolio anytime without worrying about where the markets are heading. While the equity investments can pull the overall portfolio returns, arbitrage funds tend to bring a sense of steadiness to them. The returns generated by arbitrage funds are not too high but the ‘risk-free’ nature is their ‘high point’. The ideal time horizon for investing in these funds is one year or more to avail the tax advantage.

Now whether the markets zoom ahead or fall backwards; markets will always continue to surprise us, as ‘capricious’ is its inherent nature. Why not then, ‘ride on volatility’ with arbitrage funds and make volatility work by gaining from the opportunities lying in the different moods of the market.

Prableen Bajpai works as a Research Analyst for Vantage Wealth Management (www.vantageindia.co.in). She welcomes comments, feedback & investor queries ar prableen.bajpai@vantageindia.co.in

Disclaimer: The author has taken due care and caution to compile and analyse the data. The opinions expressed above are only the views of the author, and not a recommendation to buy or sell. The author does not accept any liability whatsoever arising from the use of any of the above content.


About Prableen Bajpai

Prableen Bajpai is the Director of FinFix Advisors & Planners Pvt. Ltd., India. She has been writing about stock markets, mutual funds, economy and personal finance for the last seven years. In her previous assignment she was heading the Research at Vantage Wealth Management Solutions Pvt. Ltd. Prableen has also taught Investment Analysis and Macroeconomics to business students at the Royal Thimphu College, Bhutan. She welcomes comments, feedback & queries at prableen.bajpai@gmail.com.


For more information, please contact media@valuenotes.co.in


Disclaimer: The author has taken due care and caution to compile and analyse the data. The opinions expressed above are only the views of the author, and not a recommendation to buy or sell. The author does not accept any liability whatsoever arising from the use of any of the above contents.



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