Ar­bi­trage funds don’t suit all

Some fund houses have started side pock­et­ing in ar­bi­trage funds, but in­vestors need not panic Ar­bi­trage funds have rea­son­able exposure to debt

The Times of India (New Delhi edition) - - Times Personal Finance - NAREN­DRA NATHAN No mu­tual fund can com­pletely avoid debt-re­lated risks

Most mu­tual fund in­vestors were al­ways aware about the risks in eq­uity funds. It’s only re­cently they have be­come ac­quainted with the risks in debt funds—after mu­tual funds started ‘side pock­et­ing’ down­graded debt pa­pers. Side pock­et­ing en­tails re­mov­ing de­faulted or down­graded pa­pers from the main port­fo­lio. The NAV of the main scheme is marked down to that extent and the scheme con­tin­ues as an open-ended one. The side pock­eted scheme, cre­ated with de­faulted or down­graded pa­pers, re­mains close-ended. The money is re­turned to in­vestors if some re­cov­ery is made.

In­vestor in­ter­est in ar­bi­trage funds, a low risk prod­uct, had been high in re­cent weeks be­cause of their worry over debt funds. How­ever, some fund houses have started side pock­et­ing in ar­bi­trage funds as well. Does it mean ar­bi­trage funds have turned riskier? Not re­ally. In­vestors should not panic be­cause what fund houses are do­ing now is ‘en­abling pro­vi­sions’, or pre­par­ing for the fu­ture.

The rea­son is such schemes have some debt com­po­nent in their port­fo­lios. “Don’t as­sume ar­bi­trage funds are pure eq­uity funds. They in­vest in debt in­stru­ments when ar­bi­trage op­por­tu­ni­ties are not there,” says Vidya Bala, Co-Founder, Red­wood Re­search. This means some debt re­lated risks like in­ter­est and credit risks, will be ap­pli­ca­ble here too.

The debt com­po­nent is not high in ar­bi­trage funds as the fund houses have to keep the av­er­age eq­uity exposure above 65% to avail of eq­uity tax­a­tion benefits. How­ever, the ac­tual debt hold­ing is not small ei­ther. There are sev­eral large ar­bi­trage funds with a debt exposure of 15-20%( see chart). Though most mu­tual funds try to man­age the debt por­tion safely, it is im­pos­si­ble to avoid debt-re­lated risks com­pletely. This is be­cause a de­fault can oc­cur even in AAA rated com­pa­nies. IL&FS and DHFL were AAA-rated be­fore be­ing down­graded.

high when the mar­ket is go­ing up or when it is volatile. How­ever, ar­bi­trage op­por­tu­ni­ties re­cede when the mar­ket slides,” says Lak­shmi Iyer, Head of Fixed In­come and Prod­uct, Ko­tak Mu­tual Fund. In other words, be ready for short-term volatil­ity in ar­bi­trage fund re­turns. Though the av­er­age re­turn is around 6%, it is high for a few months and low for the rest.

Volatil­ity in short-term re­turns can also oc­cur be­cause of the mark to mar­ket val­u­a­tion rules. What ar­bi­trage funds do is si­mul­ta­ne­ously buy in one mar­ket and sell in an­other mar­ket to corner the price dif­fer­ence. Let’s as­sume that a scheme buys In­fosys for 780 in the cash mar­ket and sells it for 800 in the 3-month fu­ture mar­ket and pockets the dif­fer­ence—`20 or absolute re­turn of 2.6% for three months. How­ever, this locked-in profit can be re­alised only when the ar­bi­trage trade is fi­nally set­tled. The scheme will be forced to report losses if the gap widens in be­tween. Ar­bi­trage funds re­port­ing small daily losses is thus com­mon.

Not for short-term in­vestors

To keep away short-term play­ers, most ar­bi­trage funds charge an exit load if you with­draw your money within a month. Since ac­tive fu­tures and op­tions con­tracts in In­dia are for three months, the short-term marked to mar­ket volatil­ity is high for this time pe­riod. “Don’t use ar­bi­trage funds as a sub­sti­tute for liq­uid funds and park your money for a few months. Ar­bi­trage funds should be used only if the hold­ing pe­riod is at least four months,” says Vi­jay Sing­ha­nia, Founder & Di­rec­tor, Trade Smart On­line. Bala feels the ideal hold­ing pe­riod for ar­bi­trage funds is a year. “If the hold­ing pe­riod is less than a year, it is bet­ter to be in less volatile overnight debt funds. The one year hold­ing pe­riod also makes it tax ef­fi­cient, at­tract­ing long-term cap­i­tal gains tax of only 10%,” she says.

Not for long-term too

“Though the risk is low, ar­bi­trage fund is not a long-term prod­uct be­cause re­turns are also lim­ited,” says Sing­ha­nia. This is be­cause ar­bi­trage strat­egy used to con­tain down­side risk also caps its up­side. The pos­si­ble gain here is only the locked-in profit. Long-term in­vestors should con­sider growth in­vest­ments like eq­uity mu­tual funds in­stead. Tax­a­tion ad­van­tage of ar­bi­trage funds against debt funds also di­min­ish when hold­ing pe­riod is above three years. The dif­fer­ence be­tween 10% tax and 20% tax after in­dex­a­tion ben­e­fit is not much.

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