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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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There has been a spate of Derivative or Arbitrage Funds being launched, the most recent one being SBI Arbitrage Opportunities Fund. What is an arbitrage fund and what should investors look for before investing in one? The article addresses these and related issues.

But first a little background. Sometime back the markets were at an all time peak. And then the much feared correction arrived. Just when investors were almost giving up hope, the market turnedaround and crossed the 12000 mark again. In such volatile situations, what is an investor supposed to do?

Most astute investors book profits at regular intervals and milestones. And then when the valuations fall, they buy into bargains. Buy low and sell high is the only way to make money on the stock markets and those who actually do end up making the money follow this mantra regularly. (Also read - Invest, but choose the right mutual fund)

Anyway, say you have sold some shares and booked profits. What will you do with the money? Some money can go back into stocks. But at this point you might not want to commit all your funds to equity. At the same time, you wouldn't want to lock up your funds for any length of time. You never know when the market will provide an opportunity next and you will like to keep your money reasonably liquid.

Income funds are not the answer. Interest rates being on the upswing investors would have to undertake a heavy "interest rate risk".
Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Therefore, in the past when interest rates were falling linearly year after year, most income funds yielded returns that even a well doing equity fund would be proud of. This is done by adjusting the portfolio to the market rate of returns is called 'Mark to market'. However, this article is not about the mechanics of the interest rate risk. (Also read - Low on risk? Here's how to earn better returns)

In simple words, when interest rates in the economy rise, the NAV of an income fund falls and vice versa. Therefore, as of now, investors have to look elsewhere...some place that gives them fixed return at a very low risk.

Enter Arbitrage Funds

Investors not familiar with this type of scheme might just end up thinking that these are just equity-oriented schemes with another fancy name. However, this is not so. What such funds aim to do is to take advantage of the arbitrage opportunities between the cash and the futures market to generate fixed income. Therefore, these are a type of income scheme.

The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market. Let's understand how this works. (Also read - How to build your MF portfolio?)

Suppose the stock price of XYZ Ltd. is quoting at Rs. 600. Let's say the stock is also traded in derivatives segment, where its future price is Rs. 610. In such a case, one can make a risk-free profit by selling a futures contract of XYZ Ltd. at Rs. 610 and buy an equivalent number of shares in the equity market at Rs. 600.

Now when settlement day arrives, it wouldn't matter which direction the stock price of XYZ Ltd. has taken in the interim. In other words, it is irrelevant whether the share price of XYZ Ltd. has risen or fallen, one would still make the same amount of money.

This happens because...

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