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The Decline Of Arbitrage Funds

The changes in the operating environment of arbitrage funds have made them less attractive...

Arbitrage funds saw a major decline in their assets in 2010, as investors redeemed 84 per cent of their investments. In all, 18 arbitrage funds had Rs5,976 crore in December 2009, out of which Rs5,022 crore got redeemed last year.

The funds that saw the highest drop in their assets under management (AUM) in the last one year were Birla Sunlife Enhanced Arbitrage (95.33%), HDFC Arbitrage Wholesale (94.60%) and ICICI Prudential Equity and Derivative Inc Optimiser (92.27%).

The reason for the departure of assets in this category? Poor performance. This category delivered on an average 4.26 per cent (2009) and 5.84 per cent (2010) over the past two years.

Though never a mainstream product, arbitrage funds had gained prominence in the past when sophisticated investors used them tactically to optimize returns in a tax-efficient way. The modus operandi of these funds is to invest in stocks and buy a similar position in the futures market if there is a price differential. The reward of spotting a gap in the stock price and its future contract price was the risk-free (fixed) return.

The advantage of an arbitrage fund lies in its fixed income character, but being taxed as an equity fund. Short-term capital gains tax or long-term capital gains tax (which currently is nil) are applicable for arbitrage funds. This is definitely more tax efficient than debt funds, as gains from a debt fund are added to the investor’s income and taxed.

Though the concept is great, minor changes in the operating environment have marred the prospects of such funds. First was the enhancement by trading platforms to accept arbitrage orders. Earlier, dealers at brokerages used to visually monitor stock prices and their derivatives contracts on two screens to spot opportunities. Hence, returns would depend on the hard work and agility of the dealer. But in 2009, stocks exchanges enabled their systems to accept arbitrage orders, making it possible to specify orders for automatic execution on occurrence of an arbitrage opportunity. This lead to a more efficient pricing of stock futures and reduction in arbitrage opportunities.

Secondly, arbitrage funds were evaluated against short-term fixed income funds. In 2008, short-term funds started yielding higher returns with the hardening of short-term interest rates. This lead to a sustained outflow from arbitrage funds. With shrinking asset bases and reduced arbitrage opportunities, these funds invested more in short-term debt paper and in the bargain lost the advantage of being treated as equity funds.

Today, arbitrage funds deliver close to what liquid and short-term funds earn. The average liquid fund earned 4.62 per cent in 2009 and 5.02 per cent in 2010, while the average return from arbitrage funds was 4.26 per cent and 5.84 per cent, respectively.

Arbitrage funds have lost their advantage of being treated as equity funds for tax purposes and are less liquid than liquid and ultra-short term funds. They are open for subscription and redemption for only a few days in a month. Consequently, they are no longer a value proposition for investors. Going by the way assets have decreased, investors have finally come to that realisation.