A mutual scheme as an arbitrage fund

There is really little to choose when it comes to mutual funds, whatever be their name.

The schemes are ultimately equity schemes (very few debt schemes are being launched now), with probably overweightage in one sector or the other.

But JM Mutual Fund's new launched Equity and Derivative Fund at least promises something novel.

It is an arbitrage fund which takes advantage of the price differential in the cash and derivatives segment. Though it is an equity scheme, it proposes to generate income with investments in equity and convertible debentures (35-65 per cent), derivatives (35-50 per cent) and money market instruments (25-65 per cent).

 

Hedging it fine

The arbitrage fund takes advantage of the price differential in the cash and derivatives segments.

The concept involves investing in a share in the cash market and taking a simultaneous sell position in the same security in the derivatives segment -- as and when an arbitrage opportunity arises.

The concept involved investing in shares in the cash market and take a simultaneous sale position in the derivatives market in the same security as and when any arbitrage opportunity is available.

The primary objective of the scheme is capital preservation so that if, as an investor, you do not see any capital gains, at least the initial invested capital is not lost. The equity position is completely hedged from the beginning.

Towards the expiry of the derivatives contract, the positions are reversed or rolled over if arbitrage is available for the following month.

If no arbitrage opportunity is available, the fund has the option to invest in fixed income instruments or fixed income securities.

Now lets us see the mechanic of an arbitrage transaction. The fund will buy a particular scrip at Rs 100 on any day and sell the futures of the same scrip in the market for Rs 110 on the same day.

This kind of investing neutralises market risk. Any surplus cash will be deployed in the fixed income instruments such as bank deposits.

Let us take another example to understand this better. Assume that the fund has bought Grasim at Rs 300 in the first of the month and simultaneously sold Grasim futures at Rs 310.

Now assume that on the day of the expiry of the futures, the price of Grasim in the spot market is Rs 400. The profit in the cash market is Rs 100 and in the futures market is Rs 90. The net profit is Rs 10.

Take another scenario where the price of Grasim is down to Rs 200 on the expiry date.

The loss in the cash market transaction is Rs 100 and in the futures market the profit is Rs 110. Again, you are left with a net profit of Rs 10. So, either way, whether the market is up or down you stand to gain.

The main advantage lies here for people who would like to invest in the derivatives market, but cannot do so "" either because they do not understand the intricacies of futures and options or they do not have the time, or they do not have sufficient information to take a call on the markets.

Incidentally, this particular scheme is also an interval fund "" that is one can enter at any time but exits are only for a limited period during a month.

However, investors should be warned "" in a bear phase, there might be fewer arbitrage opportunities available. This is a market reality.

One reason for this is that futures might be quoting at a discount, there might be insufficient liquidity and the cost of carry might be lower than in the case of money market investments.

In such a scenario the scheme would have no choice other than to substantially invest in fixed income instruments.