Why derivative funds are attractive

Derivative funds or arbitrage funds as they are also known as, made their debut exactly a year ago. While not all the schemes have been in existence for a whole year, they have generated fairly decent returns.

In most cases, these have been superior to those of other fixed-income schemes. What makes it attractive for an investor to buy into a derivative fund?

According to Biren Mehta, fund manager, JM Mutual Fund, "Every portfolio should have some asset allocation to an arbitrage fund. That is because, it is virtually a risk- free product, completely hedged at all times and hardly impacted by the volatility in the markets."

Here is how an arbitrage fund works. The equity markets offer an arbitrage opportunity between the spot and future segments. Because of the time difference, there is a price difference between the spot and future prices of any stock.

If you are able to buy into equal but opposite positions in both the spot and future markets, these positions will offset each other on expiry, thereby resulting in an interest differential.

For example, say a share is trading in the cash market for Rs 100 and it's one-month future price is Rs 120. One can buy the stock in cash and sell the future.

On expiry, if the share price goes up to Rs 130, then you would earn Rs 30 from the share and lose Rs 10 from the future, leaving you with a net profit of Rs 20.

However, if on expiry, the share drops to Rs 90, then you would lose Rs 10, and make Rs 30 from the future. That would leave you with a total gain of gain of Rs 20. You should remember that on the expiry date, the spot and future prices converge leaving you with no arbitrage opportunity.

As a category, derivative funds have turned in superior returns as compared to other debt categories. According to Mehta, JM Mutual's Equity & Derivative fund has given an annualised return of 6.09 per cent since inception in February 2005.

Sanjiv Shah, Chief investment officer of Benchmark Mutual Fund, which was the first one to launch a derivative fund in December 2004, says "Derivative funds have given good returns compared to fixed income funds. Earlier there was a stipulation that the maximum derivatives position a fund could take was 50 per cent of its asset size."

"Now there is no restriction on the amount arbitrage funds can invest in derivatives. (They can engage in arbitrage activity unto 75-80 per cent of the asset size.) We expect derivative funds to do well going forward. The volatility in these funds is not much since they don't take interest rate risks," he adds.

The tax treatment for a derivative fund is similar to that for an income fund. For the growth option, long-term capital gains is zero, while the short-term capital gains is 10 per cent. For the dividend option, the dividend distribution tax is 12.50 per cent plus surcharge.

Those who hold for over a year are eligible for indexation benefits. The average category return amounted to 3.06 per cent, while income funds returned 2.71 per cent during the six month period.

Want to invest in a large-cap fund?

Diversified equity funds

HDFC Top 200 and Franklin India Bluechip are the two large-cap funds that have delivered good returns over a long period of time.

Besides the above two, there is another you can consider - DSPML Top 100 Equity. Though relatively new, it has done reasonably well since its launch in 2003.

Most of the other equity funds are blends. They may move across market capitalisation depending upon their outlook.

Apart from the above, you have index funds that invest only in the stocks of a particular index.

Tax-saving funds

Tax-planning funds generally are a little more aggressive because the lock-in ensures that redemption pressures will be relatively less. What this means is that since the investor cannot take out his money for three years at the minimum, the fund manager is sure that he has at least that much of money for that amount of time.

Hence, he may invest in the stocks of small companies which he believes will do well over a longer period of time.

In the category of ELSS funds, the only large-cap fund is the Franklin India Index Tax, which tracks S&P CNX Nifty Index, and hence invests only in the stocks of that index.

But do keep in mind that its returns will also be in close sync with the returns of the index, while most of the actively managed funds historically have out-performed the index funds.

Therefore, invest in it only if you would be content with returns close to that of the Nifty.

Apart from that, you would not find a single ELSS mandated to invest in large caps.

The closest you can get to a large-cap fund here is Franklin India Taxshield, which has maintained a large-cap dominated portfolio over the years. You can also consider UTI Equity Tax Savings Plan. It has also maintained its focus on large-cap stocks, though in the recent months it is turning more aggressive and investing substantially in smaller companies.

ELSS or diversified equity funds?

Your decision on how much to invest in ELSS or diversified equity funds must be based on two factors.

1. How much you need to save to avoid tax.
2. To what extent you are comfortable with the lock-in period of three years.

You can invest in ELSS funds the amount you need to, to avoid tax. Beyond that, you can go for diversified equity funds. However, if you want more liquidity, you can invest more in diversified equity funds.