Invest in Derivative Arbitrage funds

Banks, sweating to mop-up their deposits from conservative investors, have a new adversary. In addition to capital protected funds and fixed maturity plans (FMPs), mutual funds are now lining up derivatives arbitrage funds.

Typically, these funds promise safety of deposits, but claim to provide better returns, tax benefits and greater liquidity. Pru ICICI is the latest to join the list with its equities and derivatives fund.

The open-ended equity scheme aims to generate low volatility returns by investing in a mix of cash equities, equity derivatives and debt markets. The fund seeks to provide better returns than typical debt instruments and lower volatility in comparison to equity.

As Nilesh Shah, CIO, Pru ICICI, and fund manager explains, “This fund is aimed at an investor who seeks the returns of small-savings instruments, safety of bank deposits, tax benefits of RBI Relief Bonds and liquidity of a mutual fund.”
Pru ICICI already has two plans under the ICICI Blended Scheme, which specialise in arbitrage trades.

This basically means the fund seeks to buy stocks in the cash market and sell the corresponding stock futures to lock-in the price difference between the two, i.e the arbitrage spread. However, this fund will have additional features as in use of options (covered), index arbitrage, pair trading and alpha generation.

This, Mr Shah, feels will mean returns better than a vanilla arbitrage fund. Currently, most arbitrage funds earn annualised returns of around 7.25%, which is nearly the same as that of one-year fixed deposits. Whether a retail investor should opt for such a fund when its returns only match that of a bank deposits is open to debate.

Prior to ’05, Sebi guidelines allowed only 50% investment in derivatives for a mutual fund. In February ’05, JM financial was the first to launch a proper arbitrage fund where the fund was positioned as a 50% in debt and 50% in hedged equity.

Since then quite a few arbitrage funds have mushroomed. Besides, stocks available in F&O counter have increased from 53 stocks in ’05 to 123 stocks now, increasing the opportunities for all funds. Such funds with its investments in cash segments hedged in the derivatives segment basically serve as a variant of a capital protection fund, feel analysts. However, capital protected funds are compulsorily close-ended.  Pru ICICI has now stopped taking subscriptions for its Blended Plans as it feels the opportunities for arbitrage at this stage in derivatives market are limited. Asked whether entry of more MFs in this space will reduce opportunities for arbitrage, Biren Mehta, fund manager of JM’s arbitrage, said this is unlikely.

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