How investors can better leverage the power of arbitrage-funds

Topics Covered

• Understanding Arbitrage Funds conceptually
• Consider the tax implications
• There is scope for alpha in arbitrage funds

Understanding Arbitrage Funds conceptually

It is interesting to understand how an arbitrage is actually done. Let us assume that Reliance stock quotes at Rs.1000 and Reliance April Futures (expiring on April 28th) is quoting at Rs.1007. The fund manager will therefore buy the Reliance equity at Rs.1000 and sell Reliance Futures at Rs.1007. This spread is also referred to as the Cost of Carry and it becomes the assured return for the fund manager. That translates into a return of 0.70% (7/1000) for a period of 18 days or roughly (14%) annualized returns. But the 14% returns are not earned by the fund. There is a transaction cost, statutory charges and operating cost that the fund needs to bear. All this will probably wipe off 2-3% from the returns and leave the investors with an annual return of around 11%. But what is so attractive about an 11% return?

Consider the tax implications

In terms of risk profile, an arbitrage fund is more akin to a debt fund than an equity fund. This is because an arbitrage fund tends to operate on spread and does not assume any directional risk in the market. To that extent its returns are nearly assured, if not entirely assured. Hence it is more comparable with debt funds in terms of risk and return profile. That is where the big advantage comes in terms of tax implications. For tax purposes, arbitrage funds are treated as equity funds if they have 65% exposure to equities. As a result, dividends paid out by arbitrage funds are tax-free and also the dividends do not attract any withholding tax at the hands of the fund. In terms of capital gains, arbitrage funds are exempt from long term capital gains while short term capital gains are taxed at a concessional rate of 15%. This raises the returns of arbitrage funds in post-tax terms vis-a-vis debt funds.

There is scope for alpha in arbitrage funds

Alpha refers to excess returns that a fund can earn over and above what the general market earns. In debt funds, the scope for alpha is limited since interest rates and credit quality tends to impact all debt funds equally. However, in case of arbitrage funds there is scope for Alpha and that can be used by fund managers to earn their extra return for their fund. Here are two such cases where alpha can be drawn from arbitrage funds.

Dividend arbitrage is a popular way of gaining alpha in arbitrage funds. This is how it works. Since futures do not earn dividends, the futures tend to quote at a discount to the extent of dividend. The fund manager may take a view that the actual dividend will be higher than normal and he can bet alpha on the current spread. This happened when the PSU companies were giving higher dividends at the behest of the government. This created a huge opportunity for arbitrage fund managers to bet on higher dividends and earn higher arbitrage spreads.

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The second way to earn alpha is to bet on market volatility. When markets become volatile, the spreads in many stocks tend to become negative despite there being no dividends. This could happen when the Volatility Index (VIX) goes up sharply resulting in aggressive selling in the futures market. Fund managers can use this opportunity to proactively unwind their arbitrage position and earn additional returns due to the volatility.

This combination of dividends and volatility spreads gives an added advantage of alpha to arbitrage funds that do not exist in case of debt funds. When you add up the tax benefits in case of arbitrage funds, you have a product that is not only smart but also compelling for investors. It is time to look at arbitrage funds more seriously.