Risk-free Earners

Of late, there has been an avalanche of bad news flowing out of the Indian stock markets. The Sensex tottering around the 14K mark, the Nifty around the 4K mark, the plummeting stock prices of most companies, mutual funds failing to garner any positive returns... the list seems to go on and on, and on. Amidst all of these sob stories, we have become almost desperate for some positive information. Well, look no further.

While the markets have been crashing around us, there has been one category of mutual funds that have actually generated returns in the green. They are the Arbitrage Funds. Quite often referred to as equity-and-derivative funds, arbitrage funds are an ideal way of earning a reasonable income from equities with the modest amount of risk, And here's how. The objective of an arbitrage fund is to capitalise on a stock's price difference between the spot market (cash segment) and the derivatives market (futures & options segment). These funds basically generate income by taking advantage of the arbitrage opportunities arising out of the mis-pricing between the two markets (spot and derivative).

Let's illustrate this concept with a hypothetical situation. Let's suppose that the stock of Company XYZ is trading at Rs. 500 in the spot market. Simultaneously, the stock is also being traded in the derivatives market where the stock future is priced at Rs. 510. Now, when an arbitrage fund manager sees such a mis-pricing, he sells a contract of the XYZ stock future at Rs. 510 and buys an equivalent number of shares at Rs. 500 from the cash segment. In this way, he earns a risk-free profit of Rs. 10 per share (minus relevant transaction costs). The best part about such profit earnings is that they can come irrespective of the overall market movement.

Furthermore, on the settlement day of the derivatives segment, the stock prices in both the markets tend to coincide. So, the fund manager will reverse his transaction - buy a contract in the futures market and sell off his equity holdings in the spot markets - and earn more profits. An arbitrage fund carries out a number of such transactions to generate favourable returns.

Sounds highly appealing, doesn't it? Well, arbitrage funds have clearly outperformed debt funds and the returns of an arbitrage fund become tax-free after a year, but these funds have a few concerns as well. The main concern would be a bloating asset size. If the AUM of an arbitrage fund increases heavily, then a majority of the assets would remain parked in money market instruments simply because of the lack of enough arbitrage opportunities. However, it is not time to be overly concerned as yet because more and more stocks are being introduced in the derivative markets, hence broadening the investment universe for arbitrage funds.

So, should you opt for an investment in arbitrage fund? The facts and figures sure support the cause. Arbitrage funds offer better returns than debt or income funds and their earnings become tax-free after a year. But, increasing assets could be a cause of concern, albeit not yet. The category currently manages a moderate amount of assets and is made up of 10 funds. But the deciding factor could be that arbitrage funds generally thrive on volatility. The higher the volatility in the markets, the higher is the potential of mis-pricing between the spot and derivatives markets. Hence, at a time like now, when the markets are at their volatile best, arbitrage funds might just turn out to be the most favourable form of investment.