Question 2: Name mutual fund types with near zero probability of money-loss?
I am big fan of lowering risk and tax. Before I save and invest I try to choose instruments with minimum risk and tax out-go. Of course the type of risk differs: loss-of-money-risk when saving and loss-of-value-risk (or inflation risk) when investing. Choosing instruments for investing (for long-term goals) is much easier than choosing instruments for saving (for short term goals), simply because there are more options for saving. A typical everyday example is choice of debt funds: most investors are confused about which debt fund to choose when.
When I first started learning about debt funds, I asked myself a variant of the above mentioned question: Identify a class of debt fund which has near zero probability of money loss. That is, it has never given negative returns, over, say, any one-year period since inception of the fund.
The answer: liquid funds. Why is this important? To me (a self-proclaimed contended investor) managing risk is more important than returns. I cannot stomach any kind of risk for short term goals. For long term goals I have forced myself to accept the volatility in returns is necessary to offset loss of value risk. So I invest 60% of what I can invest each month in equity. Rest is in debt instruments. I can stomach some amount of volatility in debt instrument returns for long term goals. I simply cannot stomach any volatility in returns for short term goals. So even if a goal is 2-3 years away I prefer to choose only a liquid fund.
For such durations ‘experts’ would recommend a short-term fund or an income fund. However these funds have lost money and therefore can lose money. So no thank you I will stick to liquid funds (btw, not all rear view mirror driving is harmful). Experts cannot see past returns most of the time. One of many reasons why we should do our own research: first on our temperament and then on products.
However this is not about me or about liquid funds. This is about answering question 2. Or more specifically, is there any fund, besides a liquid fund, with near-zero probability of money-loss. The answer and the topic of this post (finally!): Arbitrage Mutual Funds
To understand how arbitrage mutual funds operate we must understand what an arbitrate opportunity is. Took me a while to get this until I put it together in the form of an example: Pondicherry is a favourite destination of those who love a drink or four! Due to difference in duties and other taxes, alcohol is much cheaper there than in neighbouring Chennai (and of course whole of TamilNadu). So if I buy crates of alcohol in Pondicherry (at MRP), find a cheap means of transport, and sell it in Chennai (at MRP) I will make a profit equal to the difference between the Chennai price and Pondicherry price. Of course the profit will be diminished by the transportation cost.
Ignoring legal aspects, this price difference is known as an arbitrate opportunity. There are two key points to note:
- The profit is small as I gain only from the price difference
- The profit is Risk-free. Tomorrow if the union govt decides to make alcohol prizes uniform the arbitrate opportunity is lost. However I lose no money (I can simply stop the business before the law is enforced).
Do arbitrate opportunities have zero risk? Theoretically yes. In practice my consignment can get destroyed in transport. My usual customers may turn teetotallers etc. So risk under unusual circumstances cannot be ruled out.
How do mutual funds which exploit arbitrate opportunities work? Firstly it is important to know that many, many types of arbitrate opportunities exist which these mutual funds can exploit. I half-understand only one. So I am no expert. The following is not wrong but lacks a quite a bit of finesse you would associate with an expert.
A stock can be traded in (at least) two ways: (1) you buy/sell for what it is worth today in the so called cash market. (2) You enter into a contract and agree to buy/sell it in future at a price agreed upon today. This is knows a futures contract or simply futures. An arbitrate opportunity arises when the cash market price of a stock is different from the futures market price. Reasons for this difference are not yet clear to me. All I know is that it is related to efficiency of information transfer in the stock market which is not perfect.
If the futures market stock price is lower than the cash market price, I buy stocks from the futures market and sell in the cash market. Soon people will become aware of this price difference (partly because of my action!) and the price will be same after a few days or earlier. Before the prices equalize I make a profit equal to the stock price difference (transaction costs will have to be accounted for). More importantly the profit is risk free. When the prices equalize I will look for a different arbitrage opportunity.
Like mentioned before arbitrage opportunities are subject to risk when the market crashes. This risk is of course different from the everyday market risk which equity funds are subject to. That said many Indian Arbitrage funds (ones I checked) survived the 2008 crash with no dip in NAV.
Here is the icing on the cake: Arbitrage mutual funds are taxed like equity mutual funds. Gains realised by holding units for more than a year are tax free. So they are the answer to the titular question: Arbitrage mutual funds are risk-free AND tax-free instruments.
Returns: Typically returns of arbitrage funds are similar to those of liquid funds and ultra-short term funds, that is about 6-8%. Arbitrage opportunities abound in turbulent markets and they have done quite well in recent times. Returns should not be a factor for choosing them though.
Potential Uses of Arbitrage Mutual Funds: The tax-free and risk-free nature of such funds can be exploited in many ways:
- They are ideal candidates for short-term goals where capital protection and minimum tax-outgo are more important than returns. Since losses can arise under unusual circumstances it is best to use it for non-crucial short-term goals (a year or more away).
- They are decent candidates for parking a portion of your emergency fund. A SB account and liquid funds are ideal candidates in terms of liquidity. A small portion can be kept in arbitrage funds so that we can let it grow without worrying about tax. Note: Redemption can take about 10 days or so.
- When we have a home loan going it is best to set aside about 3 months EMI as part of the emergency fund. This part alone can be put in an arbitrage fund since liquidity is typically not crucial.
I am thinking out loud on the following. Feel free to disagree and correct me if I am wrong:
- If gold can form 10% of a diversified portfolio why can’t arbitrage be a small part of it? It certainly has all the necessary qualities. It performs well in a turbulent market and gives steady (but low returns).
- Can it be used for tactical asset allocation? One way of reducing risk in a portfolio is to completely exit equities when the index surges higher and higher with a correspondingly high P/E ratio and re-enter at a low enough P/E ratio. At least some part of the portfolio can be shifted to arbitrate funds to minimize tax. Of course if a crash hits there could be some loss while holding the arbitrage fund. However it should still be lower than that associated with a typical equity fund.
- When a long term goals nears its dead line the equity component must be shifted to debt. While this makes the corpus safe the corpus now becomes subject to tax. Perhaps at least a portion can be shifted to arbitrage funds to minimize tax and risk? Perhaps even a STP (equity to arbitrage) can be set up towards the end of the investment tenure?
Can you think of anymore uses for these funds?
- What is arbitrage?
- Examples of arbitrage opportunities
- Example of arbitrage opportunity in Indian Stock Market
- Arbitrage Funds: Do they work too hard for too little?
- Pure arbitrage funds provide highest post-tax returns: Study
- Arbitrage funds outpaced Debt and Equity Mutual funds
Disclosure: I use UTI Spread Arbitrage Growth – Direct Option.
Postscript: UTI also stands for urinary tract infection. So if you type 'UTI Spread' in a search engine the first few hits will not be about mutual funds 🙂
Update: I have changed 'financial instrument' in the title to 'mutual fund'. This seems to be confusing. I received PPF and tax-free bonds as answers to the rhetorical question!