When the markets tanked around 500 points many investors were disappointed. However, there is a set of people who enjoy such volatilities. They are waiting for volatile times in a bull market and are hawkishly waiting for mispricing opportunities to be created so that they could gain from mispricing in the cash and futures markets. These are the arbitragers. They have been fast gaining currency in the investment market by providing a steady performance. Returns from arbitrage funds have been around 8 to 9% in the past few months.

Now, this does not seem so attractive. But if compared with other funds in the income category, especially after deducting taxes, the returns at around 6.5 to 7% and look far better than even fixed deposits that have been gaining attention. This is because arbitrage funds fall in the ?equity? category and attract lower taxes as compared to liquid funds and other debt based options, like fixed deposits.

Little wonder then that these funds are fast gathering investor attention, especially from the retail segment of the market. ?Of late, retail investors, especially high net worth individuals have been attracted towards arbitrage funds,? says Shailesh Jain, a fund manager from Lotus India Asset Management, who manages an arbitrage fund.

The attraction of the arbitrage fund comes from the fact that there are near risk-free returns to be made here. By its very definition, arbitrage, means getting risk-free returns by seeking price differentials between markets. So the returns are risk-free. Now, with the markets getting choppy, the returns are strong. And even better than many other exiting fixed income investment options. ?So on the risk returns matrix, the arbitrage funds stand out as a great option,? says a wealth manager with a multinational bank. He has been advising many of his HNI clients to have a significant portion of their portfolio shifted from liquid funds and income funds into arbitrage funds.

Modus operandi

But are arbitrage funds totally risk-free? Before we dwell into this question, knowing how an astute arbitrage works is important. Earlier, the arbitrager would sit across two monitors, one having prices of stocks listed on the National Stock Exchange and the other the Bombay Stock Exchange. The idea was to spot price differences between these markets.

Buy in one and simultaneously sell in the other to gain from the difference. However, with markets getting sharper and the security transaction tax (STT) coming in the transaction costs having risen, the pricing advantage has been nullified to a great extent. ?The price differential is now very narrow and one would require huge amounts to really gain, so this type of arbitrage is not all that attractive now,?says Jain.

The game now takes place in the spot (cash) and the futures market. Volatile prices and overall excitement-led activity often create strong pricing mismatches between the spot and futures market. Ideally, the spot price should be such that it clearly has a futures price that reflects the holding period and the interest rates in the market place (there are other parameters as well). But many a times, there is a difference and the arbitrager takes advantage of these ?mispricings? to make a risk-free return.

Suppose the stock price of XYZ company is now is quoting at Rs 100. And the quotation of price in the futures segment in the derivatives market is Rs 110. In such a case, the arbitrager can make risk-free profit by selling a futures contract of XYZ at Rs 110 and at the same time buying an equivalent number of shares in the cash market at Rs 100. So this is the first leg of the transaction which involves selling a futures contract and buying in the cash segment.

Now after waiting for a month, or the contract expiration period, on the settlement day, it is obvious that the future and the cash price tend to converge. At this time, the arbitrager will reverse the position. Sell in the cash market and buy a futures contract of the same security. This is the second leg of the transaction.

There could be two possibilities in such a situation. One, the share price has risen substantially in the holding period, and has now become Rs 200. In that case, the arbitrager makes money on the profit on the sale of Rs 100 share at Rs 200 and a loss on the sale of the futures contract. And if the price declines to Rs 50, then the arbitrager will gain from the sale of the derivatives contract and take a loss on the sale of the shares in the spot market. Either ways, there is a gain. There are other gains to be made while rolling the contract over and taking advantage of further mispricing.

The risk, however, lies in pulling this off. There are sufficient risks involved in seeing that transaction is pulled off at the given rates. The situation quoted in the example involved a large price differential. In actual circumstances, the differences are not as wide.

They are fine differences and not getting the transaction through at these prices is a risk, says V Pandey, an arbitrage fund manager from SBI Mutual Fund. He adds, ?As long as there is a significant segment of investors who are willing to pay a cost of carry to have a leveraged position in the markets, arbitrage funds will exist.?

Jain mentions that most of the risks associated with arbitrage funds are rather theoretical in nature and will not exist in reality. ?Of the hundred and eighty stocks in the futures segment, there will be at least a couple of stocks that are mispriced. Don?t you think so?? asks the wealth manager.

So we have fund managers using savvy software packages that are crunching numbers constantly to spot mispricing opportunities in the market. And this seems to be working at the moment.

The game

?Ideally, a volatile bull market works well for arbitrage funds. There are several opportunities that come across,? adds Jain. He mentions that when markets are volatile and are in a bull phase, arbitrage funds will tend to do well. It is only in prolonged bear phases that the arbitrage funds could get hit.

?Returns will come down if interest rates come down sharply or equity markets turn negative,? says Pandey. But even here, an optimistic Jain adds, there will always be some stock and some opportunity that the fund manager can avail of. Like there are stocks that lose in a bull market, there will be stocks that will gain in bear markets, so opportunities will exist.

Jain also adds that mispricing opportunities are also created when a market falls sharply. Innovative rollover strategies can help maximise the gains, he adds. He does agree that a sustained bear market could definitely reduce returns significantly.

From an investing perspective, Jain adds gleefully, the investor will not lose much. Arbitrage funds also have the option to park their funds in short-term debt market funds. ?At the worst, you will get a return provided by a liquid fund,? says Jain. So there is not much of risk that an investor has to take. This has been realised by a lot of investors and hence there has been an increased attention given to arbitrage funds.

Ideal mix

?Investors can park their short-term surplus with arbitrage funds,? says Pandey. But Jain is of the view that around 10 to 20% of a portfolio should be allocated to these funds. ?I would actually look at a similar figure,? says a wealth manager who reckons that exposure from short-term debt instruments should be now allocated to arbitrage funds.

Jain also advises investors to take a three to six months time-frame while investing in arbitrage funds. Clearly, one of the reasons is that investors have an exit load of 0.35%. Now it looks to be a small load, but in the overall reckoning it eats into the total returns.

Moreover, like any investment, there is a gestation that takes place. For a derivative position to unfold its true potential it takes around three to six months. This is because futures contracts are for a month. So a strategy to roll over, hold, buy or sell requires three to six months to fructify.

Jain also adds that investors tend to forget redemption clauses and could get upset if they tend to redeem close to a contract settlement. Other than this, he believes that there should be an increasing number of investors queuing up for arbitrage funds.

Indeed, when the markets get choppy and you need to have a definite amount of investment being made in arbitrage funds, they have the ability to anchor a portfolio, says a wealth manager.

So while equity investments pull the overall returns, arbitrage funds will tend to bring a sense of steadiness to it.