#BQMutualFundShow: Arbitrage Funds Ideal For Short-Term Investment In Low-Risk Product

An arbitrage fund is ideal for those who want to invest for the short term in a low-risk product, Vijay Mantri of Buckfast Financial Advisory Services said on BloombergQuint's weekly series, The Mutual Fund Show.

Arbitrage is an opportunity to benefit from price inefficiencies of a given security in two different markets, mostly between spot (current) market and derivatives (futures) market. Essentially, these funds don't take any directional bet on equities and just lock in the spread available between the cash and futures markets. The returns depend on the spreads one can make between the cash and futures position.

Mantri recommends a minimum holding period of three months for arbitrage funds. The returns will be low up to three months or marginally negative if held for a month, he says. “If you go beyond three months, then the volatility evens out because most of the futures and options expire by that point,” he explains.

Here are edited excerpts from the interview.

An arbitrage fund is a fund which is absolutely safe because it doesn't take any open equity position. And since it is an equity-oriented product, the return becomes tax free.

Suppose you are in an arbitrage scheme and it invests in ICICI Bank shares. So, if they buy ICICI Bank shares in the open market, at the same time they will sell the shares in the market. Suppose they are buying at Rs 250 in the open market, they will sell at Rs 252 in the futures market. So when they buy and sell, they exactly know what's the spread they are playing with and net of expenses what kind of return they are getting. The reverse can also happen. If they sell ICICI Bank shares in the spot market at Rs 250 and 15-30 days down the line shares are available in the futures market at Rs 248, then they buy. So, in ICICI Bank, in that particular arbitrage fund, the mutual fund is not carrying open ICICI Bank positions. Every position which an arbitrage fund takes, it takes contra positions of similar quantity. So, there is no reason your money could be unsafe for whatever reason.

In arbitrage, since the entire exposure is to equities, and under the Income Tax Act, if you are investing in a mutual fund which invests more than 65 percent in equities, the gain from that mutual fund scheme becomes tax-free if you hold for one year.

If that mutual fund scheme declares a dividend, the mutual fund scheme doesn't pay dividend distribution tax, but the dividend becomes tax-free in the hand of the investor. So, you have huge tax advantage available when you invest through equity schemes. But it is not a traditional equity scheme where you take a huge risk of prices moving up and down. This is a scheme where every position is squared off with a contrary position. So, as an investor, you don't take any risk at all.

The downside is that if the market goes up 50 percent, you don't make 50 percent. Either way, you make only 6 percent.

Secondly, there is greater acceptance of mutual funds as a product. When you want to invest in a mutual fund, you examine various things and arbitrage is one of those things. So, awareness and tax structure...

Also, a lot of money is lying around to be moved into equities. So, instead of putting it in a liquid fund, a lot of people will put it in an arbitrage fund and then switch money into equity funds. So, a combination of all three has helped the arbitrage funds'assets under management to shoot up.

The right comparison is looking at FMP. If you have a three-month FMP, one-year FMP, you know at the end you will get that kind of return. But if you have invested in three-year FMP and if after one month, interest rate in economy shoots up, even that FMP's NA will go down. But you know that you are holding it for three years and you know you are going to get to get those kinds of returns. So, that is the reason we tell our investors that if you are investing in an arbitrage fund, you should have a minimum three-month horizon.