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Why should one invest in Arbitrage Funds?

Published on Mon, Oct 09, 2006 at 14:46 | Source : Moneycontrol.com

Updated at Thu, Oct 12, 2006 at 16:53

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This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place --- buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, the investor earns the spread between the purchase price of the equity shares and the sale price of futures contract.

Examine the following table

	Scenario I	Scenario II
XYZ Price at settlement	700	500
Profit/Loss on sale of equity shares at expiry	100	-100
Profit/Loss on purchase of stock Future at expiry	-90	110
Net Profit	10	10

In Scenario I, XYZ Ltd. skyrockets to Rs. 700 on the settlement date. At this point, the price will be same in the equity and futures markets. So when you sell the stock, a profit of Rs. 100 is earned. However, you also buy back the stock future thereby incurring a loss of Rs. 90. End result, a net profit of Rs. 10 is earned. The same thing happens even in Scenario II where the share price crashes to Rs. 500. Still you will end up with same profit. (Also read - Learn to invest in equities without an iota of risk)

Yes, it does sound like a very simple and effective way of making money in the market. After all, the problem that most investors have with entering into the equity market is the lack of assured risk free returns. And now here is a product that gives you exactly that. However, if only life were indeed that simple.

The first hurdle is the presence of arbitrage opportunities. In a given period of time, the market may or may not provide any meaningful arbitrage opportunities. And as explained above, it is these arbitrage opportunities that hold the key to the amount of money the fund will earn. No doubt, the fund management team will have to be extra vigilant in identifying such opportunities.

Of course, nowadays, they have sophisticated softwares that flag such mispricing the moment it occurs. However, investors do have to take into account the uncertainty of the supply of arbitrage as a hurdle in earning returns. For this very reason, such schemes cannot assure returns, the returns totally and completely depend upon available opportunity.

Secondly, there is the issue of costs. Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail the payment of these costs. Therefore, it again comes down to the presence of the arbitrage opportunity and it being meaningful enough i.e., after the payment of the expenses, the left over profit if any, should be material enough to make the transaction worth entering into.

To Conclude

Investors should note that by definition such schemes will always yield limited returns. However, the risk free nature of the returns is the USP of the product. Like mentioned earlier, if you want your funds to take a pit stop from the jet setting pace that the stock market has set, such a scheme will be an ideal shelter. Also, with the abolition of Sec. 80L, most fixed income earning avenues won't cover inflation post taxes. However, in the case of non-equity MFs, dividends are subject to only a 14.025% distribution tax, thereby again creating an arbitrage opportunity for taxpayers in the highest bracket. If one chooses the growth option and stays invested for over 1 year, capital gains tax @10% or @20% with indexation has to be paid. (Also read - Bank FDs or FMPs: What must you choose?)

This then becomes another alternative apart from Fixed Maturity Plans & Floating Rate schemes to beat the risks inherent in income schemes. Those wanting a breather from the equity market and those looking for safe fixed income should invest.

- Sandeep Shanbhag

The author is the Director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be reached at sandeep.shanbhag@moneycontrol.com

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