Arbitrage funds: For uninitiated investors seeking moderate returns

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In the past fortnight, the Sensex has hit a high of 52,000 points, fell to 49,000 points and has recovered back to 51,400-odd points.

The market has moved around 6,000 points in around 10-12 trading sessions. Clearly, the volatility has been quite high. At the same time, debt funds have come under scrutiny because of the Rs 30-000 crore Franklin Templeton fiasco that impacted as many as 300,000 investors.

An interesting category, in such circumstances, is arbitrage funds. These are funds that are made for investors who want to profit from the volatility in the stock market without taking too much risk. What makes them interesting is that a fund manager can take advantage of the price difference of a stock between the current and futures market. For example:

If a stock ‘X’ is trading at Rs 100 in the cash market and Rs 102 in the futures market, the fund manager will simultaneously buy from cash and sell in the futures market. The difference between the two prices – Rs 2 in this case – is the investor’s return.

Another instance of arbitrage is the price difference between the two exchanges – the Bombay Stock Exchange and National Stock Exchange. In this case, when there is a price difference in stock between the two exchanges, the fund manager will buy from and sell in the other. Again, a risk-free return for the investor.

Besides taking advantage of the price difference in equities, these schemes also hold highly rated debt instruments such as term deposits and debentures. This ensures that the scheme continues to earn safe returns, in the absence of any arbitrage opportunities.

“Arbitrage funds have very little risk because they do not take direct exposure to equities. There is a little risk that there might not be enough arbitrage opportunities to generate good returns,” said Arnav Pandya, founder, Moneyeduschool.

Such schemes do not indicate any returns to the investor, but the returns are largely risk-free. On average, the returns are moderate in the range of 5-7%.

However, for an investor looking to earn moderate returns through a mix of little debt and equity, this is ideal. What is important for an investor in such schemes is the expense ratio since frequent churning of the portfolio may lead to higher costs.

Usually, the expense ratio is around 75 to 100 basis points. However, since the returns of such schemes aren’t exceptionally high, it makes a dent in the returns. If you can take the direct route, it would make much more sense because the expense ratio falls sharply to around 25-50 basis points.

The best thing about these schemes is the tax treatment. “The other benefit is that they have favourable taxation similar to equity funds,” adds Pandya. That is, the returns will be taxed at 10 per cent after one year.

According to Pandya, investors who want returns like debt with a lower tax impact should consider arbitrage funds in their portfolio.