How Arbitrage Mutual Funds Work: A simple introduction

Published: June 23, 2016 at 6:58 am

Last Updated on

Arbitrage mutual funds suddenly came into the spotlight after the recommendations of Budget 2014, which adversely affected investors in debt mutual funds.

They would now have to wait 3 years to apply indexation benefits to their capital gains from debt funds. For durations below or equal to three years, gains will be added to income and taxed as per slab.

As a result of increased inflows to such funds, returns appears to have come down recently? More on this later. This post was first published on Jul 17th 2014.

arbitrage-returns
Notice the marked drop in returns post-2008.

Arbitrage Mutual Funds

A hitherto unknown and not-so-well understood class of mutual funds is now in the spotlight for two reasons.

  • The gains by investing in these funds is tax-free after one year because they are classified as equity mutual funds.
  • The gains come at near-zero, long-term (1-year plus) risk.

Thus instead of investing in an FD offering 8-9% returns and  getting 6-7% post-tax, why not invest in Arbitrage mutual funds, get about 6-9% tax-free?

  • After all returns from arbitrage mutual funds are independent of interest rates.
  • All these funds escaped the 2008 crisis.
  • Recall that even liquid funds were affected by the July 2013 bonds crash!

Sounds enticing does it not?

I had earlier written a purely non-technical introduction to arbitrage mutual funds. If you are interested in knowing more about these funds, start from there: The tax-free and risk-free investment

In this post, I would like to provide but slightly more technical but jargon-free description of arbitrage mutual funds.  How to select such funds will taken up in a future post.

Note: I am not a market expert and am only trying to share my understanding here.

Disclosure:  I use arbitrage fund UTI-Spread as part of my four year old sons marriage goal instead of a debt fund. No particular reason. The goal is not as crucial as retirement or his education. So I thought, I will give it a try instead of a debt fund! I do not regularly contribute to it. CAGR: ~ 8%

Warning:

  • Arbitrage mutual funds operate in a complicated way and can be subject to new risks because of sudden increase (and therefore decrease) in AUM.
  • DO NOT start investing without understanding what you are getting into.
  • If your short-term financial goals are crucial, DO NOT use them.
  • DO NOT use them for goals just a few months away. They are not a replacement for liquid funds, ultra-short term funds or FMPs.
  • Returns can vary quite a bit and are not guaranteed (not one bit!). An arbitrage opportunity has to exist to obtain a return.
  • Do not blindly listen to the advice of your mutual fund advisor of fee-based financial planner and invest large sums in arbitrage funds. They may be under pressure from the AMC to ‘push’ such products.

How do they work?

The first task is to understand what an arbitrage opportunity is and how it is risk-free to exploit it.

There are many different arbitrage opportunities: in the stock market, in the commodities market, in the forex market etc and there are different types of arbitrage within each market.

We will look at just one type of arbitrage opportunity in the stock market.

To make thing specific, let me quote the following from the scheme information document of IDFC Arbitrage Fund (btw when in doubt, read the scheme information document!)

The Scheme will endeavour to invest predominantly in arbitrage opportunities between spot and futures  prices of exchange traded equities. In the absence of profitable arbitrage opportunities available in the market, the scheme may predominantly invest in short-term debt and money market securities.

Let us try to understand what the first sentence means.  Hopefully, the second sentence would be clear on its own.

Seeking arbitrage opportunities between spot and futures  prices of exchange traded equities is known as Cash-n-carry arbitrage. We will discuss other types of arbitrage in a another post.

Spot price

The spot price of a stock is its current price. This is the price quoted in business channels and financial portals. When you buy or sell a stock using a demat account, the stocks are delivered or off-loaded immediately at the price applicable when bought or sold.

Futures price

In the futures market, the buyer and the seller do not exchange stocks (or commodity) immediately. The stocks change hands at a future date, but the price is fixed at the time of agreement. Thus, a contract is arrived at.

The contract price per stock can vary from day to day and the contract can be traded in the futures market.

If after  the purchase of a contract, the selling price of the contract increases,

  • the person who agreed to sell stocks at a future date, loses money because he is obligated to sell at a lower price.
  • Similarly, the person who agreed to buy stocks at a future date, gains because he is obligated to buy at a lower price.

When the futures contract expires, the selling price of the stock in the futures market would typically be equal to the selling price in the cash market. Let us say, this is Rs. 11 per stock.

An amount of Rs 1. x 100 ( change in price x no of stocks) is deducted from the sellers account because he would have to sell at a higher price.

The same amount is credited to the buyers account because he would have to buy at a higher price.

The futures contract seller can now actually sell his stock at Rs. 11 per stock. He would receive 11 x 100 = 1100.

The futures-contract-sellers gains in the cash market (stock sells at Rs. 11 while selling, instead of Rs. 10) is offset by the loss in futures market.

The futures-contract-buyers gain in futures market will be offset when he buys the stock selling at Rs. 11 instead of Rs. 10.

Thus, the effective price of both the futures buyer and seller is only Rs. 10.

In this case, the futures-buyer is said to have hedged his risk by entering into a (futures) contract. He buys the stock at an effective price of Rs. 10 even though it is priced at Rs. 11. The futures-seller has neither lost nor gained.

Similarly, had the stock price decreased to Rs. 9 upon expiry of the contract, the futures-seller would have gained money from the contract while the futures-buyer would have lost money.

However, after the expiry of the contract, when they actually sell/buy the stock, they would do so at an effective rate of Rs. 10.

In this case, the futures-seller is said to have hedged his risk by entering to a futures contract. He sells the stock at an effective price of Rs. 10 even though it is trading at Rs. 9. The futures-buyer has neither lost nor gained.

Arbitrage Opportunity

A difference between the stock price in the futures market and the spot market, is referred to as an arbitrage opportunity. This difference arises due to inefficient flow of information between the two markets and is temporary.

As the due date of the futures contract expiry nears, the difference decreases and the prices tend to become the same.

More arbitrage opportunities are available when the markets are volatile.

If the futures stock price is lower than the spot market price, people would prefer the former. The increased demand will increase the futures stock price. There would also be pressure on the spot stock price to decrease. Soon the two prices will converge.

Thus although the difference in price (arbitrage opportunity) may exist at one point in time, it will diminish rapidly.

Here is how one can profit from such an opportunity.

Let us say.

Futures price of a stock = Rs. 10

Spot price of the same = Rs. 8

Suppose you simultaneously buy 100 stocks in spot market and sell 100 stocks of the same company in the futures market. That is buy 100 stocks immediately in the stock market and you agree to sell 100 stocks at some time in the future  (futures contract)

When the futures contact expires, the futures price and spot price would have converged.

Let us assume that both are now equal to Rs. 9.

So now, you simultaneously sell 100 stocks in the spot market at Rs. 9 (a profit of Rs. 1 per stock) and fulfil the futures contract by delivering or selling the 100 stocks at Rs. 10 (a profit of Rs. 1 per stock).

Thus there is a risk free profit of Rs 2 per stock. Risk-free, because the difference between spot price and futures price is almost certain to be extinguished when the futures contract expires.

You would gain from both actions:

Selling at the stock market and using it to fulfil your sell obligation at the futures market.

Thus, you have made Rs. 2 per stock via an arbitrage opportunity: mis-match of pricing between the spot market and futures market.

What if

Futures price of a stock = Rs. 8

Spot price of the same = Rs. 10

You simultaneously sell 100 stocks in spot market and buy 100 stocks of the same company in the futures market. That is sell 100 stocks immediately in the stock market and you agree to buy 100 stocks at some time in the future  (futures contract)

Wait a minute, how can stock that you do not own in the first place be sold? You can borrow stock under the Security Lending and Borrowing Scheme (SLBS) and sell!

However, this comes with fee, conditions (margin calls) and collateral. I can’t claim to know much about this. The bottom-line, the profits will reduce in this case, due to the increase in fees.

If  you can spare a moment to think about what will happen when the price is Rs. 9 in both markets when the contract expires, you will recognise that the profit again is Rs. 2 per stock.

Arbitrage mutual funds use such opportunities to make small gains.

Even if the stock market crashes, the risk does not increase, because spot price and futures prices will only converge rapidly.

However, although the two prices do converge they need not converge steadily. They will be intermittent fluctuations in the difference between the two prices. At times the difference could increase from what it originally was.

Suppose you started with

Futures price of a stock = Rs. 10

Spot price of the same = Rs. 8

And at some point before  the expiry of the contract, we have

Futures price of a stock = Rs. 11

Spot price of the same = Rs. 7

Had you done nothing, this increase in the price difference would not have affected you.

What if you wanted the money right away? Or to make it more specific, what if the arbitrage fund manager is a faced with a large redemption and has to liquidate his holding?

He/she would have to  simultaneously sell 100 stocks in the spot market at Rs. 7 (a loss of Rs. 1 per stock) and fulfil the futures contract by delivering or selling the 100 stocks (a loss of Rs. 1 per stock).

Thus, since the difference between spot price and futures prices has increased from Rs. 2 to Rs. 4, the loss is Rs. 2.

The difference between spot price and futures price is known as the basis and the risk because of redemptions is known as basis risk.

If a large redemption is made from an arbitrage funds, something that cannot be handled from its cash reserves, the fund will reverse its transactions and the NAV will fall.

Arbitrage mutual funds reduce the chances of this in two ways:

  • Holding a good amount of cash
  • Retaining the right to refuse large redemptions until the futures contract expires. For example, S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month.

Thus, arbitrage funds are not liquid instruments.  Tread with caution.

The sudden popularity of arbitrage funds can scuttle this fund category by reducing arbitrage opportunities! Remember arbitrage exists only if information does not flow efficiently.  If there is a sudden rush to buy futures, it will reflect in the spot market, evaporating the arbitrage opportunity.

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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