Volatility is the lifeline of arbitrage funds. They thrive in a turbulent market. But when one looks at the returns of these funds over the past few years, the reality does not match up to theory.
In a span of 24 months, the Sensex plummeted from 21,000 to 8,000 levels before once again moving up to 17,000. Such a wide range of volatility in such a short span is pretty uncommon.
Somehow, this did not generate great returns for arbitrage funds. While they did perform decently in 2008, last year was not good. In 2009, the average returns of arbitrage funds was 4.26 per cent, far less than 6.08 per cent increase in the NSE Treasury Bills Index, a gauge of the performance of money market. Their returns were also much lower from the 8.59 per cent they returned in 2008. Even the best performer returned 6.60 per cent in 2009 as compared to 10.60 per cent by the best performer in 2008.
The past two quarters (September and December 2009) were especially bad for these funds which gained just 0.97 per cent and 0.66 per cent in the third and fourth quarters, respectively. The NSE T-Bills Index gained 1.67 per cent and 1.17 per cent during the same period.
For a long time, the returns of arbitrage funds have also closely followed the returns of liquid funds. But this has not been the case in the past few months when they have lagged behind even the returns of liquid funds.
Arbitrage funds capitalise on price differentials between the spot market (cash segment) and the derivatives market (Futures & Options segment). Higher the volatility, more are the chances of mispricing of securities at the spot and derivatives markets. Although they can increase their returns by taking naked equity exposure, it would affect their risk profile.
Swelling arbitrage fund assets mean lesser marginal returns. Beyond a level, the fund manager comes across fewer arbitrage opportunities and is forced to park money in fixed income instruments. When the assets under arbitrage funds started to grow around June 2009, their returns started affected. Some schemes even suspended new subscriptions for a while.
The fund manager targets opportunities that can pay him more than the return on short-term debt. When interest rates dropped, opportunities were exploited at lower spreads, in turn reducing their returns. Over the past year, their average allocation to debt has been at about 23 per cent. Now when the interest rates are headed upwards, the fixed income investments of these funds might also feel the heat.
Market pricing efficiency is the enemy of an arbitrageur. Opportunities abound when there are opposing views on the street. In the new software based ordering system, the system itself throws up opportunities that satisfy the cash-future spread limit as set by the fund manager. This makes the whole process quick and more efficient, taking away the chances to generate higher returns.
Being taxed as equity funds, they offer a tax advantage over the income funds. But significantly lower pre-tax returns are not enticing. With a risk higher than liquid funds and low returns, think before investing in a such a fund.
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