Fund Basics: How arbitrage funds work

With an average return of 9 per cent in the last one year, arbitrage funds outdid diversified funds in a volatile market, although their long-term performance lacks lustre.

How do arbitrage funds outperform in a declining market? These funds aim to generate income by using arbitrage opportunities between the cash market and the futures (or derivatives) market.

Arbitrage gains can typically be achieved by taking advantage of the mis-pricing that exists between the cash and the derivatives market. For example, let us assume that the stock of ABC Company is trading at Rs 200. Let us also assume that the stock is traded in the derivatives segment as well, where its future price is Rs 210.

In such a situation, an investor, theoretically, will be able to make a risk-free profit by selling a futures contract of ABC Company at Rs 210 and buy an equivalent number of shares in the cash market at Rs 200.

When the settlement day comes, it wouldn’t matter which direction the stock price has taken in the mean time, as the price of equity shares and their stock futures tend to coincide on the date of expiry (settlement date).

Now, the initial transaction has to be reversed, that is, buy back the contract in the futures market and sell off the equity. This enables an investor to earn a spread of Rs 10 between the purchase price of the equity shares and the sale price of futures contract, irrespective of the share price.

Different opportunities

Arbitrage opportunities increase in a volatile market. This is because heavy volatility leads to more mis-pricing in cash and futures markets.

Mergers or takeovers between companies also provide arbitrage opportunities in stocks.

Events such as buy-back of shares, too, trigger such opportunities due to difference in the buy-back and the traded price.

During declaration of dividend, the stock futures/options market can also provide an arbitrage opportunity as the stock price normally drops by the dividend amount when the stock goes ex-dividend. The mis-pricing across various indices can also lead to arbitrage opportunities.

Over the last one-, three- and five-year periods, the average returns generated by arbitrage funds were 8.15 per cent, 7.08 per cent and 7.02 per cent respectively.

Limitations

Funds such as ICICI Prudential Blended Plan - Option A, IDFC Arbitrage - Plan A (Regular) , JM Arbitrage Advantage, Kotak Equity Arbitrage, Reliance Arbitrage Advantage and SBI Arbitrage Opportunities returned more than 9 per cent over the last one year, taking advantage of market volatility.

Arbitrage funds also have their limitations, which are particularly evident in a stable market. Mis-pricing is rarer in a stable market, and arbitrage funds normally lag in such situations.

Hence, over the long term, actively managed diversified equity funds tend to outperform arbitrage funds.

Also, arbitrage funds do incur quite a bit of expenses. The brokerage and commission involved in buying and selling futures and stocks can affect the returns of funds.

Tax perspective

Arbitrage funds are classified as equity or non-equity funds based on their average equity holdings. If the average equity component is more than 65 per cent, it will be considered as an equity fund.

Accordingly, from a tax perspective, the fund will get benefit of nil dividend distribution tax, and no capital gains tax if sold after one year.

But if this asset-allocation level is not maintained, it will be treated as a non-equity fund and will be taxed like a debt fund.

(Contributed by ICRA online research desk)

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