The Hindu Business Line : Fund Talk

Though both arbitrage funds and capital protection funds essentially target risk-averse investors, they are quite different in portfolio structure. Arbitrage funds deploy their money in a combination of debt securities, stocks and stock derivatives. They seek to generate returns from arbitrage opportunities in market — whether because of mispricing between cash and futures or between stocks in special situations such as mergers.

In the Indian context, arbitrage funds usually buy stocks in the cash markets and sell futures, to take advantage of opportunities arising from mispricing of securities. The JM Arbitrage Advantage Fund, for instance, deploys 65-80 per cent of its portfolio in stocks or equity derivatives and 20-35 per cent in debt securities.

Arbitrage funds are essentially for investors who seek "debt-plus" returns with low risk. The arbitrage funds that are currently in operation in India, JM Arbitrage Advantage and UTI Spread Fund, are open end and investors can buy or sell units at any point in time. The returns from arbitrage funds depend on the rates of return prevailing on debt investments and also the availability of arbitrage opportunities in the market.

In contrast, capital protection funds are closed end products, generally with 3-5 year terms. They invest in a combination of debt and equity. Though various alternative structures are available for capital protection funds in the global context, SEBI guidelines allow only closed end funds with a hybrid structure to offer capital protection benefits in India.

These funds usually have a 70-80 per cent allocation to debt investments, with the balance invested in equities. Investors are locked in for the entire term of the fund. The debt portion is invested in such a way that the sum invested grows at a fixed rate to deliver principal value on maturity.

The equity portion is invested in stocks of the fund manager's choice and is intended to deliver a "kicker" to the returns from the fund. The ability of the fund's portfolio to deliver capital protection is certified by an external rating agency such as CRISIL. However, the returns on the equity portion are dependent on how the equity markets perform over the three- or five-year period during which the fund is in operation.

A capital protection fund may have a higher return potential than an arbitrage fund if the equity market sharply outperforms over the tenure of the fund. However, there is a greater element of certainty associated with the returns from the arbitrage fund, as the fund manager has greater flexibility to actively manage the portfolio and allocations to generate returns.

Aarati Krishnan

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