Understanding arbitrage and whether it’s a good move to keep money in this short and sweet fund. By Hiral Thanawala

To understand the concept of arbitrage, let me tell you the story of ‘Mangesh Vada pav’ in Mumbai. Mangesh was a smart salesman at a Mumbai suburban station selling tasty vada pav to the locals. He had created a long lasting relationship with his regular customers and his popularity soared in the last five years. He was selling vada pav at Rs 15 per piece and it cost him Rs 12 to make each one. So, he was making a profit of Rs 3 on each piece. But, he was not happy with a profit of just Rs 3. So, he kept looking for opportunities to increase his profit margin.

One fine day, he tasted vada pav at a canteen located near the suburban station. The taste was similar and the cost was Rs 10 per piece. He decided to collaborate with the station canteen for the supply of vada pav. Here, he was paying Rs 10 per vada pav and was selling it for Rs 15 from his store. In this way, he was making a profit of Rs 5 by selling each piece.

This practice of buying from one market and selling at a higher price is known as “arbitrage” opportunity. Similarly, when arbitrage opportunities exist, even stocks can be purchased from one market (cash) at a lower cost and sold in another market (futures) at a higher price.

However, such arbitrage opportunities don’t last long. They disappear as information starts flowing in. On one such day, staff at Mangesh shop discussed the “arbitrage” advantage being enjoyed by his few regular customers. Soon after that, regular customers also started purchasing vada pav from canteen since it was at a lower rate. There was a rise in demand of vada pav at canteen since it was selling at a lower price compared to the market. The canteen then decided to increase the price with market rate i.e. Rs 15 per piece of vada pav. With this hike, the arbitrage opportunity vanished for Mangesh vada pav vendor.

So, understand that such arbitrage opportunities are short-lived. This is being considered as a short window of opportunity that needs to be exploited by taking timely action. As information flows, the arbitrage opportunity vanishes as we saw in the case of Mangesh vada pav vendor.

What are arbitrage funds?

Arvind Rao, Proprietor at Arvind Rao & Associates, a chartered accountancy firm explains, “Arbitrage funds take advantage of mispricing of securities in different markets. Traditionally, arbitrage is also referred to as riskless profits. Since its investment objective is pure to profit from mispricing.” Explaining portfolio of arbitrage funds, Krimica Sojitra, Research Analyst at TBNG Capital Advisors, says, “This fund invests into equity and debt instruments. The equity portion is usually the hedged portion wherein arbitrage strategy is applied. While investing in debt, fund managers deploy funds into short term and liquid instruments.”

Who should invest?

Investment in this scheme is best suited to conservative investors with short-term horizon between 1-3 years.

Expected returns

“Arbitrage is riskless profits, so the returns cannot be expected to be in double digits from these funds,” says Rao. Arbitrage funds’ returns are in the range of 7% to 9% without much risk to invested capital. However, “It is important to understand that returns from arbitrage funds mainly depend upon arbitrage opportunities available in the market, if the mispricing opportunities are more than fund can earn good returns, else investors would earn about the same as they would from liquid or ultra short-term funds” as explained by Sojitra.

Duration of investments

Arbitrage funds are not suitable for long-term wealth creation. They are mainly used for parking surplus money for short-term duration in a tax efficient way compared to fixed deposits. It’s recommended to have a tactical investment in arbitrage funds from short-term debt schemes for a period between 1 to 3 years.

Tax benefits

On tax benefits while investing in arbitrage funds in India Pankaaj Maalde, a Mumbai-based financial advisor explains, “Investors should know about tax returns from the product before making any investment decisions. The returns from arbitrage scheme are comparable to short-term debt funds and fixed deposits. For income tax purpose, the arbitrage funds are classified as equity funds. So, the fund will be treated as long-term after a period of one year and entire proceeds from arbitrage fund is considered as tax-free. In case, invested for less than one year then investors liable to pay tax at 15% on gains which is lesser compare to 30% tax in fixed deposits on interest earned.”

Lately, arbitrage funds are getting a higher corpus and AMCs have managed to increase their AUMs mainly due to tax benefits over debt funds. Now, the question is whether the charm of arbitrage funds are here to sustain for a longer duration? Keeping this perspective in mind, Rao explains, “Arbitrage funds have been around for more than five years in the market. After 2008, stock market correction, volumes in the fund had dried down, arbitrage funds had also lost their sheen. Currently, the taxation advantage in the short term over debt funds is what makes these funds attractive among investors. This short-term incentive is also an arbitrage opportunity, which should correct itself in due course, like any other mispricing opportunities.”

How do arbitrage funds work in Bull Vs Bear Market?

There is a perception among investors that arbitrage funds are all-season funds due to low-risk assets in the portfolio. It’s expected this fund will perform well in bull as well as bear markets. To answer investor’s perception Sojitra explains with her research, “An arbitrage fund usually performs well in a volatile market as the probability of mispricing increases. When the market is on its bull trend investments in equities in portfolio stand to benefit as futures are usually high priced than the cash, thus fund manager sells the futures and buys the stock in the cash market thus booking risk-free return. However, these funds face a challenge in a bearish market as the future would be less priced than the stock. Thus arbitrage opportunity vanishes. Observe in given table (Arbitrage funds underperforming...) that bear markets of 2008-09 and 2011 the arbitrage category has underperformed short term category funds.”

Conclusion

On whether to invest in arbitrage funds or not, Sojitra says, “The current equity market is volatile in short term due to Greek debt crisis and China’s economy slowing down, but it looks positive on the long-term trend. Even on the debt part, the current interest rate curve looks downward sloping making debt mutual funds an attractive investment avenue. In such situations, arbitrage scheme becomes a need based or should be tactical portion of the overall investments. It’s recommended to invest in arbitrage funds in a tactical manner to replace some portion of liquid and short-term debt funds in overall portfolio with a view to earn a better tax efficient return in a bullish and volatile market.”

Written By: Hiral Thanawala