Invest in Arbitrage Funds

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.

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.

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.

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 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.

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 per cent 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 per cent or @20 per cent with indexation has to be paid.

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.

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Advice on Nectar Lifesciences stock

Nectar Lifesciences came out with its IPO last year. It was priced at Rs 240. The stock is available at roughly 55 per cent of that price at Rs 130-135. Again, this company had come out with a GDR too, about a year back, where it issued optionally convertible debentures with the conversion price of close to Rs 330. So the stock looks grossly undervalued compared to its IPO price and the GDR price.

Given the fact that the company has been reporting strong earnings and good visibility of good earnings in future to take place, this company made EPS of close to Rs 28 for the financial year 2005-06. In the first quarter too, it has shown significant improvement in its topline and bottomline.

This company is undertaking various expansion projects in Baddi in Himachal Pradesh and at Derabassi, where its existing plant is located. So after those projects go on stream, this company is expected to log on much higher revenues and profits.

The company's subsidiary, which is located in Sri Lanka does a decent turnover and makes a profit of close to Rs 35 crore. So given all these factors, this stock trades as a substantial discount to its IPO price, and at Rs 130 with a P/E of 5x and with good visibility of future earnings, this stock looks underpriced.

Is it worth to buy Venky's india at Rs 137

Venky's India is a contrarian pick in the poultry industry. This company faced a very tough time in the last one year, this was primarily because of the bird flu that spread in the January-March quarter. As a result of that the operations of the company was severely affected.

The company reported a loss of about Rs 4 crore (Rs 40 million) in the January-March quarter. Inspite of that loss, the company has managed to make a profit of about Rs 11 crore (Rs 110 million) for the full year.

Now the fears of bird flu have started receding and the company seems to be getting back on track. This company is the largest player in the poultry industry and it is an integrated player in the sector.

This company is strong in the institutional segment and supplies its products to all major hotels and Indian and multinational food chains like McDonald, Pizza Hut and KFC.

When one talks of the poultry industry, Venky's is the only large player. There may be other players, but they are all small players. Venkys is probably the only national player in the sector. When one talks of the poultry industry, one  cannot even recall a number two.

So Venky's is a company where, given its size and scale of operations, it has the potential to attract institutional investors. Ofcourse they will get in after the marketcap has gone a couple of times from these levels, and after there is more visibility in terms of the company's earnings.

This company otherwise has been a consistent dividend payer and it has been paying regular dividends to its shareholders for many years now. Even when the company was faced with the worst of its times, it paid dividend to  shareholders.

Investors can use this sentiment in the company and accumulate this stock. It may turn out to be the McDowell of the poultry industry.

Know more about the UTI Mutual Fund new launch UTI Wealth Builder Fund

UTI Mutual Fund has launched UTI Wealth Builder Fund, a 5-year close-ended plain vanilla fund with an inbuilt hedging option whereby, depending on the index level, a certain percentage of the portfolio will be hedged through derivatives.

Experts believe that the performance of the fund will depend on the capability of the fund manager in making the right calls.

Investment expert Sandeep Shanbhag says, "Being close-ended, the fund manager is allowed to manage the money in a much better way as it remains locked in and hence he can take long-term calls. But, the performance of the fund will basically boil down to the competence of the fund manager in making the right calls. Also, since the fund plans to partially hedge its portfolio, it becomes critical for the fund manager to decide which stock to hedge and which not to."

On the flipside, investment advisor Hemant Rustagi warns, "The fund being a closed ended, one aims to provide investors with the benefits of long term equity investing. This by itself does not guarantee better performance than the on-going open-ended funds." "Besides, the existing funds provide investors with multiple options in terms of different investment strategies and track record", he adds.

A section of the media has pointed out that there are no new features in UTI Wealth Builder Fund except that it is close ended. However, Shanbhag says, "The simpler the mutual fund product, the better it is. This should not be a factor in the decision making. The performance of the fund will solely depend on the quality of the fund management team and only time will tell whether UTI Wealth Builder lives up to its name or not."

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Choose the Mutual funds based on your goals

We can choose mutual funds based on our goals. If funds need to be parked for contingencies, we can choose either liquid funds (if amounts are large) or short-term debt funds. There are some fund houses which gives ATM access to debt based funds.

For goals, which are 1 to 3 years away, choose debt-based funds. In a rising interest rate scenario, consider floating rate funds, while if interest rates are falling invest in pure income/bond funds.

For goals, which are likely to happen between 3 to 6 years, use combination of debt and equity based funds.

When goals are 8 to 10 years away, equity is the best option. Over the long-term, equity has usually beaten inflation by vast margins and probability of losing money is very low.

If you are new to equity investing, start with index funds. Index funds replicate the index. For example, Sensex-based index funds will invest in only those companies, which are constituents of the Sensex.

As and when you get comfortable with equity investing, move to diversified equity funds, which invest in large cap companies. Large-cap companies are well-established companies having long presence.

They are usually less volatile than small-mid companies and can withstand downturns in economy better than newer companies.

Small- and mid-cap companies rise and fall faster. On risk ladder they are more risky compared to large companies but can also give higher returns (and severe fall.) Having gained confidence with large cap companies, move to mutual funds, which invest in small-mid companies.

Once you are a 'fish in water' with volatility of equity markets, consider sector funds. These funds invest in single sector as IT, banks, FMCG. They are very high on risk ladder.

Mutual fund as an investment vehicle is the most convenient vehicle for investing in various assets classes. It gives benefit of professional management, option of investing in smaller amount, quick liquidity and diversification benefit.

Is it wise to invest in index mutual funds?

With the market climbing above 12,0000 levels, the NAVs of most equity funds are looking better than before. However, many investors are realizing that some of the funds in their portfolio have not been able to keep pace with the market. While it may have surprised new investors, most seasoned investors know that this is a normal phenomenon.

In other words, it is an established fact that different funds react differently at a time when the market is on its way up and when the market is on its way down.

It's all about the portfolio composition of the scheme i.e. the quality of the portfolio as well as exposure to different market segments that influences the level of fall and rise in the NAV. Since actively managed funds have varying degree of exposure outside index, the impact of its movement on the NAVs differs from fund to fund.

No wonder, some funds that react slowly during the initial phase of the recovery in the market, outperform others as the rally spreads to all the segments of the market. (Also read - 7 investment tips to improve your returns)

The moot question, therefore, is whether it is possible for investors to ensure that their portfolios move in line with the market. Index funds are, at times, projected as an answer to this need of certain section of investors. Considering that Index funds have been doing well on one year basis, I am sure many investors must be wondering as to why these funds should not be a part of their portfolio.

Before we analyse as to whether Index funds merit inclusion in every investor's portfolio or not, let us first understand what an Index fund is and how does it differ from actively managed funds.

An index fund is a type of passively managed fund that seeks to track the performance of a benchmark market index like BSE Sensex or S&P CNX Nifty. To achieve this intended result, the fund maintains the portfolio of all the securities in the same proportion as in the benchmark index. The offer document of an index fund clearly states as to which index the fund would track.

The major advantage of investing in an index fund is that one knows exactly the shares the fund would invest in. Besides, for an individual investor, it is practically impossible to create a portfolio that matches an index fund portfolio. The downside of investing in an index fund is that one forfeits the possibilities of earning above average returns that a good quality diversified fund may be able to provide over the longer term. (Also read - Learn how to tackle risk through diversification)

Index funds differ from an actively managed diversified fund in that trading is done not in an effort to sell non-performing securities and buy the better performing ones but to mimic a changing index and to deal with fresh inflows and outflows on account of redemptions.

Let us now analyse as to how index funds generally perform vis-�-vis actively managed equity funds. In a rising market, vast majority of actively managed funds under-perform the index funds. However, over the longer term, most actively managed funds out-perform the index funds. This happens because actively managed funds may hold superior stocks that perform better than the average and the fund manager may ride the upswing and miss the falls by actively managing the portfolio.
If we analyse the current performance data, Index funds have given an average return of 41.4 per cent on one year basis as against an average of 35.55 per cent given by actively managed funds during the same period.

However, the picture is very different over the longer term. Index funds managed to give a return of 39.58 per cent and 34.14 per cent as against 48.71 per cent and 46.15 per cent given by actively managed funds over three year and five-year period respectively. (Also read - How to build your MF portfolio?)

Though Index funds provide an inherent advantage to investors as they are charged lower expenses compared to actively managed funds, not many are able to enjoy this benefit as the holding period of Index fund investors is generally much shorter than that of investors in actively managed funds.

Besides, the ability to move in and move out gives an active fund manager a great advantage over a passively managed fund. Considering that index funds are effectively run by computers and the fact that price sensitive information keep appearing regularly, the actively managed funds have to be the mainstay of a long term investor's portfolio.

Never mind the little extra that one has to pay to an active fund manager. One needs to give one's investments a chance to out-perform the market and a portfolio of good quality funds can achieve that over the longer term.

However, for an investor who does not monitor his portfolio regularly, a blend of active and passive funds can be a good strategy. However, before investing money in an index fund, one has to be careful about the selection of the index.

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The growth rate of Mutual fund industry in india

As on September 30, 2006, the domestic mutual fund industry held assets under management of over Rs 290,000 crore (Rs 2,900 billion); a growth of nearly 46% over the last 12 months.

Other statistics reveal that a higher portion of investors' savings is now invested in market-linked avenues like mutual funds as compared to earlier times. Media reports suggest that a number of new fund houses will commence operations in the near future.

Hence investors will have an even wider range of products to choose from. Meanwhile the existing ones are keeping investors occupied by regularly launching new fund offers (NFOs).

In effect, one would be tempted to conclude that the domestic mutual fund industry has finally "come of age". However, we at Personalfn have a slightly different view on the state of affairs. Sure, the industry has grown in terms of asset size and Rs 300,000 crore (Rs 3,000 billion) could well be the next landmark. But that's hardly a reason to celebrate. More fund houses or funds don't make the industry, existence of the right ones does.

We believe that the mutual fund industry has only grown in terms of size or choices available, but is still a long distance from being regarded as a mature one. For example, for all the NFOs being launched incessantly, there are very few that can truly claim to be unique or have the ability to add value to investors' portfolios.

In fact, the industry's functioning style could well classify as a classic example of herd mentality at work. Products like monthly income plans (MIPs), mid cap funds, flexi cap funds and derivatives-based funds have found favour with various industry players at the same time.

Is it a case of all fund houses thinking alike? Similarly, the launch of NFOs has largely coincided with conducive market sentiments (read upswing in markets) and investor euphoria.

In the recent past, close-ended funds have emerged as the season's flavour. Fund houses have been quoted as saying that the close-ended nature promotes long-term investing and enables the fund manger to make investment decisions with a long-term perspective.

While we don't dispute this argument, the timing of launch of close-ended funds does make us curious. It coincides with a regulation issued by the markets regulator, the Securities and Exchange Board of India (Sebi), that only close-ended NFOs will be permitted to charge initial issue expenses.

Conversely, open-ended NFOs will be required to meet sales, marketing and other related expenses from the entry load and not through initial issue expenses. Weren't long-term investing and the other virtues of close-ended funds relevant earlier?

Another initiative which is conspicuous by its absence is investor education. It would be safe to say that most fund houses have done precious little to further the cause of investor education.

Mutual fund distributors who help fund houses garner monies continue to rule the roost. They have been lavished with attractive brokerage structures, regular NFO launches (read opportunity to make "big bucks") and other incentives.

In turn, these distributors have on numerous occasions been guilty of mis-selling and acting in their own interest, rather than the investor's. Despite this, the investor, who should be at the very core of every fund house's activity, has been left to fend for himself.

In recent times, Sebi has been forced (at an alarming frequency) to step in to aid the investor. For issues like lack of uniqueness in NFOs, method of declaring dividends, issue expenses on NFOs among others, when it seemed like the investor's interests are being compromised with, the regulator introduced measures to safeguard the investor.

This doesn't reflect too well on the mutual fund industry. Instead of playing "follow the regulator", one would expect the mutual fund industry to proactively take steps and act in the investor's interests.

Don't get us wrong, we aren't suggesting that every fund house is guilty of transgression, but most of them have erred on one front or the other. Sure some fund houses have been responsible and acted in a forthright manner; sadly, they are in a minority.

An asset size of Rs 300,000 crore shouldn't be seen as a milestone or even a reason to celebrate. Instead, fund houses should get their act in place and work towards revamping the mutual fund industry into a better and "mature" investment destination.

Mutual funds are a versatile investment avenue and hold the potential to emerge as preferred investment avenues for retail investors. Few would dispute the fact that a large section of the investing community remains untapped as far as mutual funds are concerned. Should this potential be tapped, fund houses (along with investors) stand to emerge as the biggest beneficiaries.

However, for this to happen, the mutual fund industry must finally come of age. And the onus for achieving this rests with the fund houses.

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Beware of investing in Close ended mutual funds

The almost-dead close-ended equity funds are making a comeback in the Indian market.

The mutual fund industry did begin its innings in India with close-ended equity funds. But after the initial euphoria, almost all of them ended as unmitigated disasters. As a result, the MF industry remained inconsequential for a long time.

The first sign of the industry's revival came with the introduction of open-ended funds. Since then the industry has grown quite admirably. In fact, a lot of the earlier close-ended funds have since been converted into open-ended ones.

Given the fact that things were going so well for the industry with the open-ended funds, why this sudden about turn? Why is the MF industry suddenly launching mainly close-ended funds, which were earlier resoundingly rejected by investors?

The reason is not far to seek. The answer lies in the recent changes brought in by the Securities and Exchange Board of India (Sebi) as regards the appropriation of the issue expenses of a New Fund Offer.

Before the Sebi circular came in, the MFs were allowed to write-off issue expenses of a New Fund Offer, from the fund, over a period of 5 years. Therefore, marketing expenses on new funds, usually about 6% of the corpus raised, were incurred and written-off from the fund over the next five years.

Since, these expenses were written-off over a period, the NFOs could open at par. Also, quite a few of them were introduced with no up-front entry load.

With the new guidelines, this has been stopped. Now in an open-ended NFO, all the expenses have to be either met out of the entry-loads or netted off from the fund on day 1.

It is difficult to assume that anyone would be willing to pay 6% entry load, especially after being used to the so-called no-load funds. As a result, an open-ended NFO will always open at NAV below Rs.10. This will attract the ire of the investors and they will, over a period of time, stop investing in NFOs.

Or alternatively, the AMCs (asset management companies) would have to bear such expenses, eating into their profits.

Since the rules of the game have not changed for close-ended funds, there is a sudden newfound love for such close-ended NFOs.

A part of the blame, of course, lies with the investors too. They have all along believed that an NFO at Rs 10 NAV is cheaper than an existing fund with an NAV of say Rs 100. As a result, they have been willing to invest thousands of crores (billions) in an NFO, but will not invest even Rs 1,000 in an existing fund with a proven-track record.

Hence, the only avenue available to the MFs to increase their AUMs (assets under management) was to come out with NFOs, similar to the ones they were already having. And as a marketing strategy, some of them were introduced with fancy names to attract investors.

As it is, investing in NFOs makes little sense, unless they have something different to offer from the existing funds. Without the benefit of a known track record, one cannot make an informed judgment. And to compound the problems, in a close-ended fund you can't even get out and rectify your mistake in case the fund does not perform well.

SIP (Systematic Investment Plan) is the best way of investing in equity markets, especially in today's volatile markets. Close-ended funds, by their very nature, do not facilitate SIPs, thus taking away a very important risk-mitigating strategy.

One small advantage of a close-ended fund is that it makes the investor take a long-term view of the markets.

But all the other negatives far outweigh this benefit. Moreover, a smart and well-informed investor can derive this benefit by staying invested in an open-ended fund too.

As regards the fund manager being able to take a long-term view instead of having to manage short-term performance, fund managers have done a commendable job in the past in managing open-ended funds and there is no reason why they cannot continue with the same performance in future too.

All in all, there is a need to look at the close-ended funds really hard before putting in one's hard earned money.

The solution lies in investor education and MF distributors have to play a very important role. Instead of looking at short-term profits at the cost of the investors, whose interests they are supposedly serving, they must work towards building a strong and ethical MF industry.

This is in everyone's interest: the mutual funds, the investors and the distributors.

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