Since October, the Bombay Stock Exchange Sensitive Index, or Sensex, has been trading in a range of 1,500-2,000 points. In a range-bound market, investors generally look at arbitrage opportunities. Often there is a price differential between the cash and futures market in a particular scrip. This differential can also arise between two stock exchanges.
In such circumstances, an investor can buy in one market, sell in another and pocket the differential. An example should make this clear. A company stock is trading on BSE at Rs 30 and at Rs 30.50 on the National Stock Exchange (NSE). This price differential will allow a trader to buy in BSE and sell on NSE and earn a profit of 50 paise per share.
Then, there are mutual funds which specifically follow this strategy – arbitrage funds. However, in the last six months, the performance of arbitrage funds was quite dismal. Arbitrage funds have returned between 0.8 and 2.36 per cent.
Even the annual returns are not too impressive. The average annual return of 17 funds is 3.83 per cent. The best performing fund, JP Morgan India Alpha, has returned 5.51 per cent and the fund at the bottom, Benchmark Derivative, has annual returns of 2.79 per cent.
Fund managers said there were several reasons why arbitrage funds have not performed well. One, despite the market being range bound, there were few arbitrage opportunities. “More arbitrage opportunities arise when retail investors’ participation in the futures and options (F&O) is high. Derivatives trades (from retail) are nowhere close to what they were between 2007 and 2008,” said Rajan Mehta, executive director, Benchmark Asset Management Company.
Importantly, the securities transaction tax (STT) has adversely impacted returns. “When the returns are not significant, expenses and taxation do eat into the returns,” said a fund manager.
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Kanwar Vivek, chief executive officer, Birla Sun Life Distribution Company, feels increasing use of quant-based trading has affected the returns from arbitrage funds in a big way. “These mathematical models execute large trade at one go, thereby shrinking arbitrage opportunities further,” says Vivek. Quant-based models execute large orders of buy and sell. Consequently, the arbitrage window is reduced substantially.
Arbitrage funds had their best annual returns during 2007 to 2009. Schemes such as UTI SPrEAD gave an annual return of 10.92 per cent in the January 2008- January 2009 period. HDFC Arbitrage Retail had 9.38 per cent returns in December 2007- December 2008.
Currently, their returns are at par with short-term debt funds (liquid and liquid plus schemes). The category average for liquid funds is 5.13 per cent and for liquid plus, 4.46 per cent.
Other than performance, these schemes are low-risk, almost like debt schemes, which attracts investors. Since the transaction – buy and sell – takes place immediately, there is no risk of holding the shares. “Theoretically, their returns cannot be negative. And, it has not happened until now,” said a certified financial planner.
The tax treatment of arbitrage funds is similar to that of equities. If a person stays in the fund for more than one year, the returns are tax-free. In case of redemption within a year, the person would need to pay short-term capital gains tax of 15 per cent. Taxation makes these more attractive than debt funds.
However, market experts feel investors should not look at arbitrage funds anymore because of the problems. “Investors, who got into arbitrage fund to have an equity exposure at low-risk, should look at monthly income plans that have equity exposure up to 15 per cent only,” added Vivek. Even debt funds investing in short-term instruments could be a good option.
