Everything that goes up comes down. And if you want proof of this, you need look no further than the Sensex. After December 2007, it keeps inching up only to fall flat once again.
This roller-coaster ride has probably given the weak-hearted equity fund managers cardiac problems. In the first seven months of this year, diversified equity funds have given -36 per cent returns. Debt funds, the so-called safe haven for investors, gave -0.36 per cent in June 2008. The last bastion of hope, Gold Exchange Traded Funds (ETFs), are also showing signs of weakness by turning in -3.33 per cent last month.
The trick is in finding an asset class, which offers some protection to avoid erosion of capital. The only way out is to opt for an asset class whose returns are not linked to the stock market. This way, the investors would be able to shield their capital from market turbulence.
Among the 29 categories of funds in the market, Hybrid Arbitrage funds fit the bill. These funds actually follow a very simple and age old strategy of buying low from one market and selling high on another.
Historically, traders used to buy goods from one country and sell them in another country at high prices. This is called arbitrage. The difference now is that such trade has become more sophisticated than before. Fund managers now take the help of computers to capture the arbitrage opportunities that may even exist for just a few seconds. These funds typically buy stocks in the spot market and sell, at the same time, in the futures market. In effect, they hedge their investments. At the time of delivery, they profit from the spread in the future-spot market. Moreover, corporate actions such as dividend declaration, buy-backs, mergers or de-mergers also provide arbitrage opportunities in the futures-options markets.
The unique advantage of these funds is that though they buy stocks and futures in the equity markets, their strategy of simultaneous transactions in the spot and futures/options market make their returns neutral to the debt or equity market performance. The first arbitrage fund was launched four years back by Benchmark. Currently, this category consists of 14 funds. Though these funds are available all through the year, their performance during this bear run has set them apart. This year, these funds have outperformed both the Sensex and the equity diversified category by 34 and 40 per cent respectively.
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Arbitrage funds are ideal for risk averse investors who are absolutely averse to any depreciation in their capital. Moreover, these funds are more tax efficient than debt funds, as they are treated in line with equity funds. In comparison to the all other variants of funds, arbitrage funds are the least volatile.
| ARBITRAGE FUNDS As on August 21, 2008 | ||||||
| Funds | Launch Date | Assets (cr) | 6 month | 1 year | 2 year | Expense Ratio |
| Benchmark Derivative | 4-Dec | 18.52 | 2.8603 | 7.2407 | 7.7949 | 1.5 |
| ICICI Pru Equity & Derivative Income Optimiser Retail | 6-Dec | 160.15 | 2.8394 | 7.2155 | — | 1.5 |
| ICICI Prudential Blended Plan A | 5-May | 66.69 | 3.0833 | 7.7219 | 8.6139 | 1.5 |
| ICICI Prudential Blended Plan B | 5-May | 5.53 | 3.2116 | 8.3288 | 8.3607 | 1.49 |
| IDFC Arbitrage | 6-Nov | 67.27 | 2.4971 | 6.5925 | — | 1.67 |
| JM Arbitrage Advantage | 6-Jun | 240.37 | 3.3041 | 7.9114 | 8.5763 | 1.63 |
| JM Equity & Derivative | 5-Feb | 13.78 | 2.8801 | 6.9946 | 7.1757 | 1.36 |
| Kotak Equity Arbitrage | 5-Sep | 162.37 | 2.7812 | 7.393 | 8.2066 | 1.09 |
| Lotus India Arbitrage | 7-Apr | 44.92 | 3.2194 | 8.0307 | — | 1.48 |
| SBI Arbitrage Opportunities | 6-Oct | 253.02 | 2.6809 | 7.3561 | — | 1.25 |
| UTI SPREAD | 6-Jun | 180.76 | 4.1268 | 8.7726 | 8.9649 | 1 |
The prime reason why investors are not drawn to these funds is because their returns are more or less in line with the debt funds. Hence for any investor the allocation to these funds would depend on their risk appetite. But ideally, it would always be prudent to allocate around 30 to 40 per cent of one's fixed income portfolio to arbitrage funds.
SELECT ARBITRAGE FUNDS
* ICICI Prudential Blended Plan A
This fund was the best performing fund in this category in 2006 and came very close to repeating that feat in 2007. In the last two quarters, it has delivered a return of 4.75 per cent. The financial services sector seems to be a favourite with the fund manager. One drawback of this fund is that it is not the most efficient in containing its cost.
* JM Arbitrage Advantage
The fund has been a solid performer delivering above average return. This fund is betting big on the construction sector and has allocated around 8 per cent of its holdings to it. This may be due to the increased volatility in this sector in recent months (increased volatility creates more arbitrage opportunities).
A major concern is that its expenses are growing, an indication that the fund probably trades very heavily. While trading generates returns, the downside is that growing expenses eat into returns.
* Kotak Arbitrage Fund
Two factors stand out in favour of this fund. It has been a consistent player in this category and its expenses have always been on the lower side. In 2007, it turned in 9.06 per cent and was ranked third in this category. But by and large, the fund's return has rarely deviated from the category average. Average returns, consistency of performance and low returns are a plus for this fund.
* UTI Spread
The sensation of 2008, this fund delivered 2.98 and 1.96 per cent in the last two quarters, respectively. If one were to look only at the arbitrage category, the fund has been an outperformer. But even if we were to include other categories, this fund will continue to stand out with a commendable performance.
In the last six months, this fund has decreased its equity holdings substantially to 0.60 per cent (from 72 per cent in December 2007). If it continues to maintain its current equity-debt allocation, it would lose its status as an equity fund and subsequently not be as tax efficient.
Value Research