Comparison of Some of the Leading Arbitrage Funds Across Key Criteria:

Arbitrage funds are a type of equity-orientedhybrid mutual fundsthat generate returns through the simultaneous purchase and sale of securities on different exchanges that feature a pricing mismatch. This is a diametrically different approach from that of the typicalequity fund, where the fund invests in equities and holds those till they can be sold at a profit in the future. In case of an arbitrage fund, the fund would typically buy a security from the cash market (stock market) and simultaneously sell the same security on the futures contracts market at a different price in order to generate a profit in the overall transaction. In a majority of cases, the difference between futures contracts and stock prices is small, hence on an average, arbitrage funds have to make hundreds of trades in a day in order to turn a profit. A secondary route of investment for arbitrage funds are short term debt and money market instruments, however, these form a relatively smaller portion of the arbitrage funds overall portfolio.

As mentioned earlier, the key to the profit generation system employed by an arbitrage fund is the simultaneous buying and selling of the same security on different markets. Commonly the two markets where an arbitrage fund trades heavily are the cash market and the futures market. The cash market is also known as the stock market and the price of a security on the stock market is termed as the spot price.

The futures market is an equity derivatives market and it works a bit differently. The futures market does not feature the current stock valuation and instead reflects the anticipated price of the stock at a future time. This future date of the anticipated price of the futures contract is termed as the maturity date. Stocks purchased on the futures market are not immediately transferred to the buyer unlike the cash market instead the delivery of those is deferred till the maturity date of the contract. On the maturity, transfer occurs at the agreed price specified by the futures contract.

Arbitrage funds leverage benefit of the difference in pricing of the stock between the cash market and the futures market. This is achieved by buying a specified number of stocks from the cash market while the same number of futures contracts is sold simultaneously on the derivatives market if the overall market sentiment is bullish. On the other hand, if the market sentiment is bearish i.e. in case a majority of investors believe that stock prices will drop, the arbitrage fund will price the future contracts at a lower price and sell an equivalent number of shares on the cash market at the current (higher) spot price.

The following is a short list of the leading arbitrage funds available for investment in India. It is notable that these funds are the ones that have historically performed well in the past, but this does not ensure equivalent performance in the future.

The Kotak Equity Arbitrage Fund is a low risk arbitrage fund managed byKotak Mutual FundAMC, a relatively new player in the Indian mutual fund sector. The scheme aims at generating returns from the various arbitrage opportunities that emerge from the pricing anomaly occurring between the spot market and the futures contracts market. Additionally, the fund would also generate income through investment of surplus funds into various fixed income instruments.

ICICI Prudential Mutual FundAMC, the JV of ICICI Bank in India and Prudential Financial of the US, manages the ICICI Prudential Equity Arbitrage Fund. This mutual fund features the stated objective of generating returns of low volatility through the use of various derivative-based strategies of the equity market including arbitrage. An additional source of income for the fund would be investments made into various short term debt and money market investments. These secondary investments would only form a minority portion of the funds portfolio.

The L&T Arbitrage Opportunities Fund is managed byL&T Mutual FundAMC, a subsidiary of the leading engineering conglomerate Larsen & Toubro. The key objective of this scheme is to generate adequate returns for investors by mainly engaging in the cash and derivatives segment based arbitrage opportunities. Apart from the arbitrage income generated from the equity market, the fund would also invest in various debt as well as money market instruments to generate additional income.

TheAxisEnhanced Arbitrage Fund managed byAxis Mutual FundAMC follows a strategy of absolute returns in order to generate income for the investors. The scheme would source a majority of its income by capitalizing on arbitrage opportunities that exist in the derivatives as well as cash segments of the equities market. The balance amount of the schemes portfolio, if any, would be utilized for debt and money market investments capable of generating short term returns for the funds investors.

The primary source of income for theInvesco IndiaArbitrage Fund is that any and all arbitrage opportunities that might be available in the equity market. Such arbitrage opportunities would primarily be obtained from the price mismatch between the cash and the derivatives markets. This Invesco India Mutual Fund AMC-managed scheme would also invest a portion of its available capital in various short term money market and debt market instruments to generate additional income.

Aditya Birla Sun Life AMC, a leadingasset management company in India, manages the Aditya Birla Sun Life Enhanced Arbitrage Fund, a top rated equity-oriented hybrid mutual fund offering available to investors. As an arbitrage fund, this hybrid mutual fund would seek out various opportunities to generate income by capitalizing on the pricing differentials of securities and equities in different equities markets. The schemes focus markets for exploiting such opportunities would primarily be the futures and the cash market of stocks. A secondary source of income generation for the fund would be short term money-market and debt investments.

The following are some of the key features that make arbitrage funds a unique class ofmutual fundsin the hybrid funds category.

Equity-Based Investments:Arbitrage funds as mentioned in the above example are mainly invested in equities as well as futures i.e. equity derivatives. On an average, these comprise at least 65% of the mutual funds portfolio. Thus for purposes of taxation and classification, arbitrage funds are considered to be equity-oriented hybrid funds. Apart from the equity portion of the portfolio, arbitrage funds also invest in a range of debt and money-market instruments including cash. The portion of these secondary investments tends to be higher when arbitrage opportunities are limited during periods of relative market stability.

Perform Best in Volatile Markets:An arbitrage fund performs best when there is an opportunity available to the fund as a result of the price differences in the spot and derivatives markets. When markets are expected to be stable in the long term, this difference in pricing is minimal hence traditional arbitrage transactions might not generate a profit after securities transaction charges/brokerage is factored in. On the other hand during periods of volatility, there is often a marked difference between the spot and futures prices, which provides arbitrage funds with an opportunity to score big. This is the main reason why the portfolio of an arbitrage fund tends to feature a greater value of equity investments during periods of high market volatility, while debt investments tend to increase during periods of relative market stability.

Equity investments limited by availability of futures contracts:Arbitrage funds in India have limited scope of making equity investments because as they can only buy shares traded on the exchange that have futures contract options available. The Indian derivatives market is relatively less developed that many other advanced markets which somewhat limits the scope of arbitrage-style investments. This limitation arises from the fact that arbitrage funds cannot make an equity investment without having the option of hedging it with a futures contract (i.e. no naked positions/options are allowed). As a result of this limitation, there are fewer arbitrage funds currently available in India as compared to many other advanced financial markets such as the US.

High Turnover/Expense Ratios:In case of an arbitrage fund, the key method of investing is to make repeated purchases and sales of the same securities simultaneously on the stock market and the derivatives markets. This process of buying and selling gets reflected in the turnover ratio of the arbitrage fund as no stock or futures contract can be held for a long period of time. Hence, an arbitrage fund will tend to have a higher turnover ratio (often around 800% or even more) as compared to most other types of mutual funds. Transactions made on the securities or derivatives markets are subject to various brokerage fees as well as applicable taxes. These transaction charges are expenses that the mutual fund includes in its expense ratio and passes on to the investor. As mentioned earlier, an arbitrage fund tends to perform numerous buy/sell transactions in a day in order to generate adequate returns hence it will tend to feature a higherexpense ratioas compared to many othertypes of mutual funds.

Low Risk Investments:As illustrated in our example in an earlier section, an arbitrage fund hedges its bets through simultaneous transactions on different markets. As a result of this hedging, an arbitrage fund can potentially make a profit no matter which direction the market moves. This is a unique feature in case of a mutual fund and therefore an arbitrage fund is considered to be a low risk investment, which is considered suitable for risk-averse investors seeking low risk equity-orientedinvestment options.

Arbitrage funds are classified as equity-oriented hybrid funds as they are mainly invested in equities and equity-derivatives such as futures contracts. Apart from their equity and equity-derivative exposure, these mutual funds feature a smaller portfolio allocation towards debt and money market investments. As a result, from the perspective of taxation, arbitrage fund investments are treated as equity investments. In case of equity investments, if the units of a mutual fund are held for a period of one year or less from the date of allotment before being liquidated, they are considered to beshort term investments. In case arbitrage fund units are held for over 1 year counted from the unit allocation date, they are considered aslong term investments.

Profits generated from a short term arbitrage fund investment are termed asshort term capital gains(STCG), while similar profits from a long term investment are termed aslong term capital gains(LTCG). As per current rules, equity investment STCG is taxable at 15% which is applicable to the funds profits. LTCG on equities is 10%. Investors staying invested for more than 1 year will have their gains taxed at 10%. They also get an annual tax exempt allowance of 1 lakh. For instance, if the long term capital gains on an arbitrage fund are Rs 2.1 lakh. only Rs 1.1 lakh will be taxable and Rs 1 lakh will be exempt. Hence the total tax payable on the gain will be Rs 11,000 (10% of the gain of 1.1 lakh). Gains made before 1st February, 2018 are also exempt from tax.

In the above situation we have mentioned how an arbitrage fund makes its transactions and in the following section we will illustrate this with an example. Lets assume an arbitrage fund purchases 100 shares of Company X for Rs. 10/share in the beginning of January and simultaneously sells 100 January futures contracts of Company X for Rs. 12. Subsequent to this transaction, 2 possible events may occur either the price of Company X shares increases by the end of January or they decrease by the end of January.

Profit/Loss of the Spot Transaction (stock market trade) = (13-10) x 100 = Rs. 300 (profit)

Profit/Loss of the Futures Transaction (derivatives market trade) = (12-13) x 100 = (-) Rs. 100 (loss)

Net profit for the arbitrage fund = 300 100 = Rs. 200.

Profit/Loss of the Spot Transaction (stock market trade) = (9-10) x 100 = (-) Rs. 100 (loss)

Profit/Loss of the Futures Transaction (derivatives market trade) = (12-9) x 100 = Rs. 300 (profit)

Net profit for the arbitrage fund = 300 100 = Rs. 200.

As shown in the simplistic example provided above, the arbitrage fund makes a profit no matter which way the market moves. In reality, however, the difference in prices of the futures contract and the spot transaction may be a lot less therefore on average arbitrage funds carry out hundreds of these types of transactions in a day.

Arbitrage funds perform best during periods of market volatility when there is a marked difference between the spot price and the futures contract price of equities. On the other hand when the equity market is less volatile, arbitrage funds may easily be outperformed by many equally low risk debt mutual funds. However, arbitrage funds do have one key advantage overdebt funds their tax treatment. Arbitrage Funds are treated as equity for tax purposes and are hence taxed at 15% if sold within one year of purchase. After 1 year, they are taxed at 10%. On the other hand debt funds are taxed at slab rate (which could be as high as 30%) for gains within 3 years. They are taxed at 20% with indexation thereafter.

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