Derivatives arbitrage funds catch fancy

Prudential ICICI Blended plan and Reliance Arbitrage Advantage Mutual to be launched soon

Derivatives arbitrage fund are in fashion. Enthused by the success of two derivatives arbitrage funds "" JM Equity and Derivatives Fund and Benchmark Derivatives Fund, two more mutual funds "" Prudential ICICI Blended plan and Reliance Arbitrage Advantage Mutual "" have launched similar products.

Others at the doorstep include Tata Mutual, Kotak Mutual, Principal PNB Mutual Fund and HDFC Mutual. The derivatives arbitrage fund was an innovation introduced by Benchmark Mutual in February this year. JM currently manages Rs 993.96 crore while Benchmark's Derivatives Fund has a corpus of Rs 118 crore.

At a time when income funds are struggling to even match deposits rates due to uncertain debt market, derivatives arbitrage funds provide an opportunity to earn steady income. In the past one month ended July 7, Benchmark Derivatives Fund gave a return of 0.31 per cent while JM Equity and Derivatives Fund gave 0.67 per cent return.

During this period, income funds returned 0.31 per cent on an average. Over the past three months, Benchmark has posted a return of 1.03 per cent while JM has delivered 1.23 per cent return.

"Since arbitrage opportunities do not present themselves always, returns in some months could be muted. But over a year or two, the fund should provide stable income," said Biren Mehta, fund manager, JM Equity and Derivative Fund.

Arbitrage funds usually seek to generate income with a combination of investments in equity, debentures, money market instruments apart from derivative instruments.

Their primary objective is capital preservation, while making steady gains from arbitrage opportunities. Usually, these funds make money by investing in shares in the cash market and taking simultaneous sale position in the derivatives market in the same security as and when any arbitrage opportunity is available.

The equity position is fully 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.

Mehta is of the opinion that arbitrage is wholly dependent on the market sentiment. "A bullish market gives rise to higher arbitrage opportunities but such opportunities may be less in flat or bearish markets," he said.

In the long run, as the Securities & Exchange Board of India plans to increase the number of stocks in the derivatives segment, scope for arbitrage may improve.

"Currently, 96 per cent of our total investible funds in the derivatives is deployed in arbitrage plays," says Mehta. The fund is allowed to invest only 50 per cent of its total net assets in arbitrage plays.

Similarly, out of the 50 per cent corpus that is allowed to be deployed in arbitrage, Benchmark has invested about 40 per cent in arbitrage, highlighting the availability of opportunities in the market.

Sometimes the cost of carry in derivatives 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. But with more players readying to launch similar funds, will arbitrage gains vanish?

Sanjiv Shah, executive director of Benchmark AMC, says, "We brought the concept and have shown very good returns so far. There is no threat of arbitrage opportunities vanishing. But too many players would obviously mean that one has to share the pie."