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Arbitrage Opportunity Knocks Again

Kotak MF has re-opened subscriptions to this category

Arbitrage funds may just have come back. At least that is the signal Kotak Asset Management is sending by reopening the doors to fresh investments in its arbitrage fund. The trend may well be set for their return as these funds thrive in a volatile stock market environment - higher the volatility, higher the chance of mis-pricing of stocks in the spot and derivatives markets. This works especially in a bull market.

Arbitrage funds stop fresh inflows if they see opportunities dwindling or if the fund size becomes too large which prevents the fund manager from optimizing returns. This is so despite the fact that the fund is open-end. The reasoning is that on a small base big gains can be registered while it is difficult to grow a large base at a very high rate.

It has been almost five months of quiet time for arbitrage funds as returns had fallen off quiet significantly as opportunities were not available. Kotak had suspended subscription to the Kotak Equity Arbitrage Fund from July 1, 2009, but now these will re-open from November 16.

However, the situation has reversed now, not so much in arbitrage funds’ favour, as it has turned against the money market instruments whose returns have fallen drastically and arbitrage funds may be offering scope for as much as 5 per cent, while these others are bandying about an amount no higher than 4 per cent.

Arbitrage funds, also known as, equity-and-derivative funds can generate reasonable income from equities, while tempering risk. The objective of an arbitrage fund is to capitalise on a stock's price difference between the spot market (cash segment) and the derivatives market (futures & options segment). These funds generate income by taking advantage of the arbitrage opportunities arising out of the mis-pricing between the two market segments - when a stock is trading at Rs 100 in the spot market, but in the derivatives market the stock futures price is Rs 110, the fund manager recognises the mis-pricing as an opportunity and sells a contract of the stock future at the higher price and buys the same amount from the cash segment. The profit is Rs 10.

More profit is arrived at when, on the day of settlement, stock prices of both market segments coincide, and the fund manager can now reverse his transaction - buy a contract in the futures market and sell off his equity holdings in the spot markets - to earn some more.

Also, returns of arbitrage funds are tax-free after one year.

Problem arises when the AUM of an arbitrage fund rises significantly. In that case the fund faces the prospect of not having enough arbitrage opportunities and has to park a major portion of its funds in money market instruments. This can lead to the loss of the tax break.

Arbitrage funds gave a positive return of 0.50 per cent return for the month of October compared to 0.37 per cent last month. Overall, till the end of October, 2009, this category has given a return of 4.15 per cent, while their 1-year returns are 5.71 per cent (as of 31 October, 2009).

The best fund over a 1-year period, ending November 16, 2009, is UTI SPrEAD-G with a 7.90 per cent returns, while the worst is Benchmark Derivative-G with a 4.15 per cent returns. Category average is 5.5 per cent.

Also Read:

And Now, 'Enhanced' Arbitrage Fund NFO
Stalling Subscriptions
The Lone Survivors

Check Performance:

Kotak Equity Arbitrage-G