Their returns have been as high as 9 per cent a year, they carry lower risks than equity funds and yet enjoy the tax breaks that equity funds do. Get an introduction to arbitrage funds from Vikaas Sachdeva, CEO of Edelweiss Mutual Fund. He talks about why the new Edelweiss Arbitrage Fund scores over other options for risk-averse investors.

Now that we have an equity market that is trending up, why should investors go for an arbitrage fund?

I think equity is a well-understood asset class in India. Every second Indian is either an equity analyst or a cricket commentator. But a lot of money gets allocated to debt as well. I think arbitrage funds have a role to play in the asset allocation toward safer instruments.

Data shows that arbitrage funds have managed to beat liquid fund returns on a consistent basis. And today, investing in very short-term debt funds for 90 days or so, whether liquid funds or FMPs, has become tax-inefficient.

Arbitrage funds are equity funds and thus enjoy a very favourable tax regime.

This arbitrage fund is benchmarked against liquid funds. Yet there are periods where short-term rates in the market shoot up sharply. Can you beat liquid funds in those periods?

There will be pockets when that happens. But we can certainly outperform over a period. On a post-tax basis, it won’t be difficult to do better than liquid funds.

Are arbitrage opportunities available in a rising equity market?

In a rising market, when everyone is gung-ho about stocks, it creates a lot of opportunities for arbitrage funds. One, when everyone is positive, that is when you get good liquidity. Two, when markets are rising, many investors want leveraged exposures and are willing to pay higher premiums for leveraging their positions. You can therefore become a counter-party to them and earn a good spread. Both conditions are good for arbitrage funds.

So what are the types of arbitrage opportunities you will be looking at?

We are planning to look at cash-futures arbitrage as well as dividend arbitrage opportunities, which is a subset of the former. In the first, you buy a cash contract (on a stock) at ₹100 and sell futures at, say, ₹101, thus pocketing a profit of ₹1 per contract.

Say, if Reliance Industries is trading at ₹1,000 in the cash market, its futures may be at ₹1,010. On the last Thursday of the month (expiry date), I have two options. I can square off both the legs of the trade or I can hold on to my cash positions, buy current month futures and sell the next-month futures once again. This reduces my transaction costs because trading in futures costs only 5 basis points, while cash market trades cost 35 basis points.

In dividend arbitrage, you buy a cash contract at ₹100 and sell it in futures for ₹99 after a dividend is declared. Thereby, your loss of ₹1 is made up by the dividend of, say, ₹2 received during this period. There is always uncertainty about how much dividend a company will declare. There is also uncertainty about the record date and whether it will fall in the same expiry. Through analysis, you can arrive at an educated guess and make arbitrage gains.

Why are arbitrage funds not so popular if they have so many advantages?

This is an underserved market, for sure. This is despite good returns from the older arbitrage products. You see, if a fund house has large liquid fund assets, they may not be keen to push arbitrage funds. But for us, this fund is a chip off the old block. Edelweiss is the largest player in the arbitrage space in India. So we bring our entire set of systems and knowledge to this fund.

Where does an arbitrage fund fit into an investor’s portfolio?

This cannot be a substitute for equity funds, which can generate high long-term returns. Nor is this a suitable product for five- or 10-year debt money. But I think if you have money to park for one year or less, this is an ideal product. It is also more tax-efficient than fixed deposits. If you hold for one year or more, you are exempt from capital gains tax. It is suitable for all categories of risk-averse investors including corporate treasuries, high net worth investors and retirees.

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