Arbitrage funds dont suit all: Things to know

Arbitrage funds dont suit all: Things to know

Most mutual fund investors were always aware about the risks in equity funds. Its only recently they have become acquainted with the risks in debt fundsafter mutual funds started side pocketing downgraded debt papers. Side pocketing entails removing defaulted or downgraded papers from the main portfolio.

Investor interest in arbitrage funds, a low risk product, had been high in recent weeks because of their worry over debt funds

Some fund houses have started side pocketing in arbitrage funds, but investors need not panic

NEW DELHI: Mostmutual fund investorswere always aware about the risks inequity funds. Its only recently they have become acquainted with the risks in debt fundsaftermutual fundsstarted side pocketing downgraded debt papers. Side pocketing entails removing defaulted or downgraded papers from the main portfolio.

The NAV of the main scheme is marked down to that extent and the scheme continues as an open-ended one. The side pocketed scheme, created with defaulted or downgraded papers, remains close-ended. The money is returned to investors if some recovery is made.

Investor interest in arbitrage funds, a low risk product, had been high in recent weeks because of their worry over debt funds. However, some fund houses have started side pocketing inarbitrage fundsas well. Does it mean arbitrage funds have turned riskier? Not really. Investors should not panic because what fund houses are doing now is enabling provisions, or preparing for the future.

The reason is such schemes have some debt component in their portfolios. Dont assume arbitrage funds are pure equity funds. They invest in debt instruments when arbitrage opportunities are not there, says Vidya Bala, co-founder, Redwood Research. This means some debt related risks like interest and credit risks, will be applicable here too.

The debt component is not high in arbitrage funds as the fund houses have to keep the average equity exposure above 65% to avail of equity taxation benefits. However, the actual debt holding is not small either. There are several large arbitrage funds with a debt exposure of 15-20%(see chart).

Though most mutual funds try to manage the debt portion safely, it is impossible to avoid debt-related risks completely. This is because a default can occur even in AAA rated companies. IL&FS and DHFL were AAA-rated before being downgraded.

Arbitrage funds also face two other risks. The first is the periodic lack of arbitrage opportunities. Arbitrage opportunities are not constant and come in phases. Arbitrage opportunity is high when the market is going up or when it is volatile. However, arbitrage opportunities recede when the market slides, says Lakshmi Iyer, head of fixed income and product, Kotak Mutual Fund.

In other words, be ready for short-term volatility in arbitrage fund returns. Though the average return is around 6%, it is high for a few months and low for the rest.

Volatility in short-term returns can also occur because of the mark to market valuation rules. What arbitrage funds do is simultaneously buy in one market and sell in another market to corner the price difference.

Lets assume that a scheme buys Infosys for ₹780 in the cash market and sells it for ₹800 in the 3-month future market and pockets the difference₹20 or absolute return of 2.6% for three months. However, this locked-in profit can be realised only when the arbitrage trade is finally settled. The scheme will be forced to report losses if the gap widens in between. Arbitrage funds reporting small daily losses is thus common.

To keep away short-term players, most arbitrage funds charge an exit load if you withdraw your money within a month. Since active futures and options contracts in India are for three months, the short-term marked to market volatility is high for this time period.

Dont use arbitrage funds as a substitute for liquid funds and park your money for a few months. Arbitrage funds should be used only if the holding period is at least four months, says Vijay Singhania, founder & director, Trade Smart Online. Bala feels the ideal holding period for arbitrage funds is a year. If the holding period is less than a year, it is better to be in less volatile overnight debt funds. The one year holding period also makes it tax efficient, attracting long-term capital gains tax of only 10%, she says.

Though the risk is low, arbitrage fund is not a long-term product because returns are also limited, says Singhania. This is because arbitrage strategy used to contain downside risk also caps its upside. The possible gain here is only the locked-in profit. Long-term investors should consider growth investments like equity mutual funds instead. Taxation advantage of arbitrage funds against debt funds also diminish when holding period is above three years. The difference between 10% tax and 20% tax after indexation benefit is not much.

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