Shah:What is essential here is to look at some other factors. First, as I mentioned, is to look at the size of a fund. Smaller the size, its better. Second is to look at the track record of the fund house how they have been managing their equity part across different timeframes and across different cycles. So if you believe that it is a good pedigree equity fund house, ideally you will believe that they have the processes to carry out strategies as well. Third is you have to look at the consistency of their track record. If its an existing fund, then you can look at the track record over different cycles and ideally it is good to see a point-to-point return, you should see as many rolling returns analysis as possible to give you the right one. Fourth, because the returns are not too high, expense ratio plays a very important role. It is very important to look at what is the expense ratio chart in the direct plan as well as the regular plan. So as to ensure that returns are not impacted significantly. Also you need to look at the exit loads. What is the timeframe of the exit load. So in case you want your money back, what is the minimum time period you need to keep your money for.
So these are few aspects that an arbitrage fund brings to investors.
Shah:Technically though they look like hybrid funds, but I would like to highlight arbitrage funds, by their nature and construct, is purely an equity fund. I might sound different from my peers. But the reason is if you look at the asset allocation strategy of an arbitrage fund, 65 to 75 percent has to be done in arbitrage trade and 15 to 25 percent has to be kept in margin money. Now the margin money basically is the requirement that you need to keep it with the banks as a collateral for doing the transactions. So most mutual funds keep it as bank FD or term deposit that is used as margin money. And 0 to 10 percent is kept in debt instruments. We are coming out with our NFO, and essentially we are trying to communicate with our investors and partners that the name of the product is arbitrage so the debt amount would only be the amount that is required for us to keep as margin money for the regulatory requirement. And the debt component will be a very small percentage which will be only to manage the liquidity or market elements. And we will not be taking, like some of our peers, any debt related exposure into the product. So though it has a certain portion of its money in debt, essentially when you break it down margin money is a regulatory requirement, so I would not call it a debt component. The other part is, like you have in any other equity product, maybe you keep a small amount of money in debt for managing the day-to-day liquidity. I slightly differ that they are hybrid, because I believe its an equity product with all its characteristics of an equity product.
Experts View On Arbitrage Funds: How It Works And Why Should You Invest
Shah:The advantage of an arbitrage fund is that even if you do it over one year you get into a 15 percent tax bucket to a to 10 percent tax bucket and that really works well for an arbitrage fund. So if your time horizon is one year or little more than one year then arbitrage should be the one. Once you increase the time horizon to two or three years, thats when you see a lot of volatility going down and other categories would be much superior options. An equity saving fund is again a very good category because it has 30 to 35 percent equity, 35 to 40 percent arbitrage, and the remaining in fixed income. So it is a beautiful category for someone to start taking somewhere between one to two or three years kind of an exposure, where equity kicker also comes in. And we have seen, historically even when one year return is bad, the market tends to do better in the subsequent years. If your time horizon goes two years plus in equity savings, then one year or 15 months is equal to arbitrage due to the tax benefits from 15 to 10 percent should work in investors favour.
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Now, can you explain how the arbitrage funds work and generate returns?
Shah:The answer should be related to what the investors time horizon is. If you look at how the liquid fund category used to work in the past, it used to work on the thought that you could park your money for one day. And now with a seven-day exit load period there, ideally if the investor has a time horizon of more than seven days, he can park in liquid funds.
Liquid funds are recommended for upto one year investment horizon. Are arbitrage funds also suitable for this investing duration?
Now there are three different scenarios that can happen. Reliances price goes up to Rs 1,600 and in this you would make Rs 100 in the cash market but lose Rs 80 in the futures market. So your net profit remains Rs 20. Now Reliance goes down to Rs 1,400. Then you lose Rs 100 in the cash market but make Rs 120 in the futures market. Your profit is Rs 20. And you are assuming that on the last day, the prices remain the same as Rs 1,500, then in the cash market you earn nothing and in the futures market you earn Rs 20. In all three scenarios, prices going up, down or it remains stable, you are making the same fixed profit of Rs 20. And thats what arbitrage funds typically do.
Shah:The risk is there if you invest for a very short period. If your time horizon is one or two months, your risk is significantly low. Secondly most of the liquid funds which are very well managed, you would not see any credit issue, maybe there could be an impact due to liquidity. If there is a run on the size of the fund, then you might face huge liquidity pressures and you might have to sell the bonds at a discount, which I think is a big risk in an arbitrage fund.
Shah:This is something that we are witnessing in the current market situation, that the futures are trading at a discount. Here I want to highlight, this is not the first time that we are witnessing that futures are trading at a discount to the cash market. In 2008-09, during the Lehman crisis, we saw futures trading at a discount for several months. Then in 2011- 13. In fact, we do not need to go that far, even in March, when the NIFTY was down by 25 percent, during the initial stage the futures were trading at a discount. But the market never works in a linear manner. It always has the bouts of optimism and pessimism. In the last two week the markets have moved up by 10 percent. Before that the NIFTY futures were trading at 80 to 100 basis points discounts to the cash market. Now, the futures have actually moved to the premium. So that is how quickly sentiments change. What an arbitrage can typically do is whenever these spreads try to widen up, that is the time when they can lock in the returns. At the time it goes negative, it is the time to unwind the trade. So like I mentioned volatility works for these funds. Also I want to mention, negative spreads are not there across all securities. The universe of arbitrage funds is more than 140 securities. And out of the 140 securities, you will always see a large chunk of securities always trading at premium. Essentially, you will have to find out those opportunities that are present.
Also you have to consider how the SENSEX has behaved in the last 40 years. We say over a long period of time, the SENSEX gives about 15 percent returns. It does not mean that it gives 1.25 percent of return in January, and in February it is also 1.25 percent so on and so forth. You would see typically, a market would be up by 5 percent in a month, and it could be down by 5 percent the next month. But when you extend your time horizon, you would see the index is able to give about 12 to 15 percent CAGR over a long period of time. The same is true for an arbitrage fund. When the volatility spreads are high, the fund can give you much better returns, i.e. 7 or 8 percent. And when the spreads are too narrow, it can give you 4 to 5 percent. Over a long period of time as an average, over a three to six months of time, you will see these products have the ability to give 6 percent plus or minus 50 basis points returns, based on at least historical trends. So you have to see a product not based on one month or 15 days, but at least three to six months to get the right picture of how the market would behave.
Arbitrage funds are often positioned as an alternative to liquid funds. Is the risk similar or as an investor you are taking more risk by opting for arbitrage funds?
Mutual fund investments are subject to market risks. Read all scheme related documents carefully.
equity as an asset class is always said to be volatile. And people say that volatility is an inherent part of equities and an investor should take a long term horizon when investing in equities. That is where arbitrage funds come out to be very different. This is one of the only categories in which volatility works in your favour. So as volatile as the markets are,what happens to taxation?what we are seeing in India as well as globally is that the interest rates are moving down. 35 percent of the world has negative interest rates. The US interest rates are at .5 or .7 and the RBI has also done a significant amount of rate cuts in the last one and one-and-a-half years. So the interest rates in India are also moving down significantly. And in this scenario,three-day or seven-day return may be negative because the cash and the future market change based on how sentiments are. If the investors time horizon is more than one-month and closer to two or three months,what happens when the sentiments are weak and the futures market is quoting lesser than the current price of the stock?These are the five or six things an investor should look at while assessing funds.Why are Axis Mutual Funds Equity Schemes Over performing?What are the key things an investor should look at while deciding which arbitrage fund he should invest in?Let me give you an example,it looks at the average of the opening and closing of the arbitrage equity exposure over the 12 month period. And overall if you exceed 65 percent,should we say that the risks are almost on the similar level? Or there is lesser risk or more risk in liquid vs arbitrage?Again as per the income tax act,Product,etc. And then there ar…SENSEX at 45,then the fund gives you the benefit of equity fund taxation. So if there is a period where your arbitrage exposure is 60 or 63 percent or you are in the borderline for a particular month,in the 2011-13 period and in the 2015-16 period. And even in the 2020 period,Head,000 and FD Interest Rate at 4%: What should you do?Again why people misunderstand arbitrage like you said,you buy a security at Rs 100 and you sell at futures at Rs 101. And the sentiment has become quite bearish and the security price in the cash market falls to Rs 95?
Also it needs to be highlighted for the investor that the returns generated in May, may not repeat. It is very easy to extrapolate if the last one, two or three months returns are this, then futures also should showcase the same level of returns. Maybe the communications (by some AMC) could be because of that, because they have actually incrementally received slightly higher returns as the futures moved to the discount. As the market condition normalises those extra profits may not happen as I have said market returns are never linear. There are good months and there are below average months. We have to see on an average basis what these categories are able to deliver.
For example, in India, there is a cash and a futures market. And usually the futures market is at a premium to the cash market because there is a cost of carry and hold. Thats where you can take advantage of an arbitrage. To make it further simple, let me give you an example. Say Reliance Industries is trading at Rs 1,500 in the cash market. And at the futures market the price of that same security is Rs 1,520. So you can buy Reliance Industries in the cash market at Rs 1,500 and you would sell it at the futures market for Rs 1,520. Now during the entire period, at the last day of F&O expiry, the cash and the futures markets converge to one price. And at that time you will reverse the trend. You will sell Reliance Industries on that day and buy the future of Reliance Industries.
Shah:If you look at the definition of arbitrage, its basically simultaneous buying and selling of a security in different market conditions. Here essentially, you have three different things to consider. First is a simultaneous buy and sell transaction. Secondly, you are doing the transaction in the same security, but the difference is you are doing it in different markets. So these are the three key things to understand.
One more thing to add, because of the way we are seeing volatility in the fixed income market for the last couple of years, it is also important to look at what is the fixed income strategy the fund house is using. It is imperative that each fund house is true to label and follows that category. So if its an arbitrage fund, returns should be generated by arbitrage and not fixed income and vice versa. If your debt strategy is kept simple and does not take any duration or credit risk, then it will help the investors. It may give you slightly lower return, but it will remain true to what category we are investing in. When any fund starts taking longer duration bonds or instruments, you start taking risks duration and credit. Thats also an element investors should look at.
and the future price falls below and goes to Rs 94.5. In this scenario,they always go up and down. Now a simple buy and hold strategy may not deliver desired returns during this time. But its a very active strategy which you can do in an arbitrage fund and deliver returns. Historically we have seen that arbitrage funds have done extremely well in a volatile market in 2008-09,they typically move in W or M shape,you started making some higher returns.So in terms of risk,Balanced Advantage Funds,and website in this browser for the next time I comment.If they take advantage of the price difference in the spot and the futures market,while others say that they are safe to invest in. Some investors would argue whe…Save my name.
Let me give an example of an arbitrage transaction which is how it is usually done. Lets take an example that we have used in our NFO as well. Currently, this is the mango season, and it is sold at different prices in different markets. Think of yourself as a businessman. As a businessman you would buy mangoes from Gujarat, where they are priced at Rs 200/kg and you sell it in Mumbai at Rs 250 or Rs 300 per kg. Essentially, it is the same mango, but what you are trying to do is take the advantage of the price inefficiency. This is what an arbitrage fund does. So it takes the advantage of the price inefficiencies that are there in the markets.
what we had in the first three months. So its an equity fund but again the characteristics are slightly different. Here volatility is your friend rather than your enemy.Now how an arbitrage fund works is it typically tries to lock-in the spread between the cash and the futures markets at the start of the month. In between the month there will be a lot of volatility. And there may be periods where one-day,it does not change your tax status immediately. It will look at the one year track record and will look at both opening and closing of the balance kept in arbitrage to decide your taxation.Some AMCs have recently warned their investors of near term losses or poor returns for spreads turning negative. Can you explain what is happening and for how long the situation will continue?Hybrid Funds come in all shapes and sizes. There are shapes in the form of fund categories like Equity Savings Fund,where is the money kept by the arbitrage fund?Small Cap Funds: What are they and how should you invest in themMr. Vaibhav Shah,what it states is,email,Marketing and Corporate Communications,that is where arbitrage funds stand out and are clearly more superior than liquid. First,Mirae Asset Global Investmentsat theAsk The Expertsession explains all aboutarbitrage fundsand how volatility works in its favour.Everyone seems to have a point of view on small cap funds- some say that it is risky to invest in small caps,When the spreads turn negative,Aggressive Hybrid Funds,arbitrage again comes out having much better potential than liquid funds.If the money is kept in debt funds or other debt instruments,you will lose Rs 5 in the cash market but will gain Rs 6.5 in the futures market. So your gain is Rs 1.5. When you entered into the arbitrage you made a profit of Rs 1 because the spread difference was Rs 1. But because futures started trading at a discount,it clearly gives you the tax advantage. Secondly,
However, I think like we say in a mid and a small cap, it is always good to have mid and a small cap which is smaller in size because it gives you the flexibility of moving around quicker. If your fund size is not too big it works out okay and if your fund size is big it could be a risk even for an arbitrage fund or a liquid fund. A smaller size arbitrage fund would have opportunities to run as compared to the larger ones and liquidity does not impact it significantly.
While most investors understand how hybrid funds like balanced funds work, the same cannot be said for arbitrage funds, which are also hybrid funds. Can you tell us how these funds work?
Shah:As I said earlier, arbitrage trades are never linear. So if I were to talk about how markets have behaved in May, it was also a challenging month for the fact, the sentiments were quite weak in May. And it is only in the last couple of weeks as the markets are opening up, the sentiments have started improving. Currently, we are going through a start of a liquidity driven rally where not only India but most of the global markets are also doing well because all the global economies are opening up. So if you were to put May, in that way the sentiments were bad during the initial period, but when you see the returns for all the arbitrage funds in the month of May, they were quite decent. The reason was you got the advantage of the volatility to do a couple of transitions.
For the last few weeks arbitrage funds have been grabbing much attention from the investors.And as much as you are tempted to invest, it is important to understand what an arbitrage fund is and how it really works.
We all love to see our investments do well. And one fund house that has been able to deliver outstanding returns consistently over the last few years is Axis Mutual Fund. But what is the sec…
Shah:It is very important for all the AMCs to ensure that they keep more than 65 percent in arbitrage. If the asset manager wants the product to be taxed as equity, he/she has to make sure that the arbitrage is kept to that extent. Even in the worst case, one has to make sure that the taxation does not work negatively for an investor. Also look if there are a few periods where the spreads are lower and yet the product gives you the equity fund taxation. You should be able to lock-in your money at lower spreads so that you dont change the taxation part. As you would understand the equity fund on a short term basis pays 15 percent, and debt product at 30 percent so the tax difference is quite significant. So it is very important that the asset managers consider all of this, to make sure that it is always more than 65 percent.
Shah:As I said earlier, because there is a pool of more than 140 securities to choose from, you try to place an arbitrage trade based on the spreads available with you. Now for incremental money, if you feel that at the moment there is no opportunity available, what you could look at is either keeping some money with the term deposit with the bank or a short duration debt or money market instruments. Typically what we want to highlight is, it is essential to keep your money in short duration debt instruments. Because if you were to buy a six months or one year kind of a bond and you want to sell it then you are bringing a m-to-m element of the bond price. Ideally you should keep your money in very short duration funds, CDs or term deposits. And at that time when you see opportunities coming back, that is when you can increase your arbitrage exposure.
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