The arbitrage opportunity

NFO REVIEW

New derivative funds have an uphill task of convincing investors that they are a low risk, high return investment.

Ever since Sebi issued guidelines in September last year allowing mutual funds to invest their entire corpus in derivative instruments (earlier the limit was 50 per cent), fund houses have been hitting the markets with arbitrage and derivative funds.

JM Mutual and Benchmark were the first off the blocks with their derivative funds. followed by UTIMF and SBIMF. Two new funds that wish to make money for investors using derivatives are the Prudential ICICI Equity and Derivatives Fund and the Standard Chartered Arbitrage Fund.

The objective of these schemes are the same: to take advantage of the price differentials between the cash and the futures segments.

Opportunities?
In a market with so many new players are there enough arbitrage opportunities available? Fund houses believe they exist.

Says Rajiv Anand, head of investments, Standard Chartered Mutual Fund, "At most times there are arbitrage opportunities available as the target universe is over 120 stocks."

Fund houses are banking on the increase in the average daily futures volumes to Rs 13,000 crore which is twice that of the cash market as well as the increased participation by FIIs.

While these opportunities exist in a bull market, what happens when markets turn bearish since funds are not allowed to short in the cash market?

The choices available to funds aren't too many. Funds can look at options, fall back on debt instruments or cap their exposure. Even in options there are hardly any volumes, especially in the far month.

Says Nilesh Shah, CIO, Prudential ICICI Asset Management, "We will manage only that much money on which we can generate an optimum return. If there are no arbitrage opportunity, we will seek return from other measures such as alpha and pair strategy, and covered calls and puts. We will cap the subscription amount if we do not get the right opportunities."

While futures and options are another instrument in the hands of a fund manager, is it enough of an incentive for the investor to change his asset allocation plan and look at these funds?

Returns
To justify an investment, schemes have to deliver returns in excess of those generated by lower risk instruments plus the risk premium involved in these investments.

A three-month treasury-bill or the average annualised returns from a liquid fund is in the range of 6.5-7 per cent and add to it a risk premium of say 4 per cent, derivative funds will have to generate upwards of 11 per cent to justify an investment.

While there are not many derivative funds, the returns track record of those that invest in these instruments is hardly inspiring.

The JM Equity and Derivative Fund has generated a one-year return of 7.31 per cent while the Benchmark Derivative Fund has given a return of 7.43 per cent.

The reasons for the underperformance could be the high cost of transaction (buying and selling cash and futures), lack of opportunities in the market and redemption pressures.

Prudential ICICI Equity and Derivatives Fund
The Equity and Derivatives fund seeks to invest predominantly in index and stock futures and options. The scheme comes with two plans: The Income and the Wealth Optimiser.

While the Income Optimiser plan seeks to generate low volatility returns, the Wealth Optimiser is positioned as a fund that will maximise capital appreciation.

There is an exit load of 1 per cent of applicable NAV if redeemed within six months from the date of allotment and an entry load of 2.25 per cent in the post-NFO period.

Issue opened on: November 8
Offer Closes on December 7

Standard Chartered Arbitrage Fund
The fund is looking at generating capital appreciation and income by taking advantage of arbitrage opportunities in the cash and the derivative segments of the equity markets.

Anand says that the fund is an equity market neutral fund and therefore should find an allocation within the fixed income part of an investor's portfolio.

Investors can enter and exit the fund at any time at NAV. For the first 30 days after entry, redemptions are subject to an exit load of 0.25 per cent.

Issue opened on November 14
Issue closes on November 30