These are not equity funds with a fanciful name. Rather, they are ideal investment vehicles for those who want debt exposure, get the tax-break of an equity investment and skip the volatility of the equity market
From an income tax point of view, equity is the most efficient asset class. The dividend income from the equity and long-term capital gains are both tax-free. From an investment point of view, equities are volatile in nature.
Arbitrage funds circumvent this problem. They act like debt funds, but their tax treatment is that of equity
diversified funds. This fund category takes advantage of the mispricing between the cash and the derivatives market. What arbitrage funds do is to go long in the cash market and short in the futures market.
In this way, the fund manager hedges the risk. Hence, regardless of market movements, the returns on equity should always be in the green.
So, while they are classified as equity funds giving investors the tax benefit, arbitrage funds do have an exposure to debt and their equity holdings are also hedged. Hence, the volatility associated with equity is missing.
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Sounds too good to be true? It is! Especially, since it’s not that simple. For starters, arbitrage opportunities don’t come by that frequently and the margins tend to be low. Moreover, there is the issue of higher expense ratios, since the nature of such a fund is to resort to heavy trading.
You also cannot expect mind boggling returns from such funds.
Not being easy to comprehend, investors gave this category a miss. But, in the stock market debacle of 2008, these funds got an opportunity to put forward their case. The category turned in 8.52 per cent that year.
You may consider this fabulous or mediocre, depending on what you compare this with. If you compare it with equity diversified funds (category average of -55.08 per cent), it stands tall. If you compare it with income funds (category average of 14.30 per cent), it is disappointing.
Currently, this category is populated by 16 funds. Post 2008, some have changed colours and have transformed into pure debt funds. We have narrowed the list down to three funds, considering their performance.
HDFC Arbitrage Retail
This fund’s trump card has been its resilience in a falling market. If we look at the period from January 2008 to March 2009, the market had been in the red for 10 months. Overall, during 11 of these 13 months, the fund has outperformed the category average.
On the other hand, in the five months when the market closed in the green, the fund has been able to beat the category average in just two months.
This fund has a penchant for the financial sector and its average allocation has been at 31.32 per cent. The sector that comes second in preference – energy – lags behind with an average allocation of 10.80 per cent.
ICICI Prudential Blended Plan A
This one has a mixed performance. In 2008, it comforted its investors with a return of 9.25 per cent, the third best in its category. But in 2007, it was third from the bottom.
Over the past one year, it’s apparent that the fund manager has made a concerted effort to cut down on the bloated stock portfolio. In 2007, the portfolio averaged at 60 stocks, which is now down to just 23. At all times, the stock portfolio has been completely hedged by going short in the futures market.
Among the stock selection, Punjab National Bank has been a particular favourite with an average allocation of 3.79 per cent since launch.
It has an expense ratio of 1.5 per cent, which is a tad on the higher side.
UTI SPREAD
One of the best performing arbitrage funds, it was a category topper in 2008 with a return of 10.60 per cent. Right from January 2008 until March 2009, the fund has outperformed the category average in 12 months. And its average outperformance has always been higher (average of 22 basis points) than that of the underperformance (4 basis points).
That is definitely a reward for its bold stance that often goes against the general market trend. Since September 2007, there has been a constant reduction in its equity allocation despite being more or less hedged at all times. This cautious move saved it from the bloodbath in the equity markets and enabled it to participate in the debt rally of 2008.
Currently, it is invested in energy (5.76 per cent), financial sector (1.54 per cent) and technology (0.42 per cent). A low expense ratio of just 0.75 per cent is an icing on the cake.