Hi, one of my favourite asset classes during times when Equity Markets were on a bull run or were volatile was ARBITRAGE SCHEMES. I had tried to allocate some portion of my clients portfolio in these schemes and made them part of the core portfolio. This gave both stability and consistent returns to my clients. Arbitrage schemes were the flavours when equity markets were on a roll. To recapitulate; these schemes follow the strategy as mentioned below:
This class of investment gives market neutral returns without taking any directional exposures to the underlying stocks & shares.
For an investor this is nothing but a BUY & SELL transaction i.e. lending money which is secured & without taking any price risks.
• Difference between the SPOT & FORWARD rate is nothing but interest rate ( traditionally known as Badla).
• This is similar to Reverse REPO undertaken by RBI with Banks or SWAP transactions in the Forex market.
• Difference between the SPOT & The FORWARD price is COST of CARRY or the interest rate.
• In the Futures market, all the trades are done on the exchange either BSE or NSE to ensure performance. However, if an investor enters into a Futures contract with a broker directly, who is a Member of any of the above named Exchanges, he runs the risk of broker default & there is no guarantee from the Exchange. Under the said circumstances, the investor is only protected to the max. of Rs.10 lacs under the Investor Protection Fund & hence is never fully protected.
• As opposed to this, if an Investor invests in Futures market through the Mutual Fund route, the Exchange transfers the transactions from participating Brokers to the Custodians & custodians are banks with large networth.
As you will recall, during bull period of equity markets, Fund managers got opportunities of locking in arbitrage returns varying between 10-15% p.a. and then unwinding the same on the expiry date or rolling it over to the next month ( if next month gave similar opportunities of locking in arbitrage returns); thereby generating close to 10-12 % tax free returns in the hands of the investors (As these schemes invest 80% in Arbitrage and 20% in Money Market, these schemes are treated as equity schemes for tax treatment purposes but with a risk profile of a liquid scheme).
Even in current times of bearish markets where arbitrage returns are as low as 5-6% & futures are going into negative, Fund Managers have been able to generate very decent higher single digit or lower double digit returns. The said is possible when Fund Manager locks in lower arbitrage yields of 40/50 bps i.e. 5-6% p.a. and when the same stock future goes into negative on days markets correct, they unwind the position earlier than 30 days.
Lets understand this better with following example:
Day 1: Buy Cash @Rs.100 & Sell Future @Rs.100.50
On day 15 Future goes into negative and quotes at say Rs.99.50; In such a situation the Fund Manager unwinds the position on day 15 and makes a clean Rs.1/- on the whole transaction ( Rs.0.50 locked in on day 1 and Rs.0.50 when Future quotes at discount) and that too in 15 days and lets the unwound position earn additional money market returns over next 15 days i.e. till the end of the month.
The above is called discount arbitrage (though not called officially, but is used as a common parlance in the Arbitrage Markets). As you will see from the returns comparative given below, that even in these bearish equity market days, the said asset class has generated very handsome returns.
If one invests in the said schemes with 6 months view, one should expect post tax return of close to 8.50-9.00% p.a. (which in the current market conditions is not available in any other asset class, except for Income/G Sec schemes with some intermittent volatility).
Let me spell out the advantages and analyse point by point whether assumptions mentioned have been proven correct or not.
Major advantages of Investing in Futures Market through the Mutual Fund Route are as follows:
1. Rate of Return is quite high. Generally Liquid plus returns. If the Fund does not get any arbitrage opportunity, then, the funds are invested in Fixed Income Securities like Liquid Funds.
2. Investment in these Schemes through the Mutual Fund routes reduces the credit risk to practically nil as the counter parties are Custodians & not the brokers.
3. If an investor invests in say Corporate Bonds; the investor is running the risks of corporate defaults. However, through this route the risk is on the Exchange which is as good as taking a Sovereign risk.
4. This is one way of diversifying your investments portfolio.
5. Investment through the Mutual Fund route has an obvious tax advantage vis a vis direct investment in the same product.
6. It is simpler to deal in complex products through the Mutual Fund route vis a vis investing directly.
Though the said product is an Equity related product, it has no price risks, credit risks, etc generally attached to this segment of investment. It is for all practical purposes a risk free investment that has the potential to give far superior returns than Liquid Funds with all the features of safety, liquidity, etc. associated with Liquid fund schemes.
Let us analyse based on some parameters & assumptions whether what we had predicted for the said asset class has been proven correct or not:
1. Has it generated higher returns than liquid & other debt schemes? Following Chart will make it clearer:
2. There have been no credit or liquidity risks even during market meltdowns from May 11’2006.
3. This was a good diversification strategy as most of the asset classes had some risks like interest rate & credit risk attached to them. The said product gave excellent returns without either of the risks attached.
4. It was a much simpler way of dealing with a complex product like this & let the professionals handle the same. They have been able to enhance returns on both counts
a. Identifying right arbitrage opportunities &
b. Enhancing returns by squaring off positions before expiry; thereby enhancing returns further.
5. It is more tax efficient way of getting into arbitrage schemes than doing it directly.
6. None of the months have Arbitrage Funds given negative returns. What this means is the Redemption NAV of each subsequent months have been higher than the previous month.-Following slide showing 1/3/6 month rolling returns will prove this assumption right
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