The lone survivors

Written by Dhirendra Kumar | Updated: Sep 28 2008, 07:04am hrs
Everything that goes up must come down. And if you want proof of this statement, you need look no further than the Sensex. After December 2007, it keeps inching upward only to once again fall flat on its face. This roller-coaster ride of the Sensex has probably given equity fund managers cardiac problems. In the first seven months of this year, diversified equity funds have turned in -36% of returns. Debt funds, the so-called safe haven for investors, have also turned in -0.36% in June 2008. The last bastion of hope, Gold Exchange Traded Funds (ETFs), are also showing signs of weakness by turning in -3.33% in July 2008.

The trick is in finding an asset class, which at least offers some protection to erosion of capital. The only way out is to opt for an asset class whose returns are not linked to the stock market. This way, the investors would be able to shield their capital from market turbulence.

Among all the 29 categories of funds classified at Value Research, there is a category called Hybrid Arbitrage funds. These actually follow a very simple and age old strategy of buying low from one market and selling high at another.

Historically, traders used to buy goods from one country and sell them in another country at high prices. This is called arbitrage. The difference now is that matters have now become more sophisticated than before. Fund managers now take the help of computers to capture the arbitrage opportunities that may even exist for just a few seconds. These funds typically buy stocks in the spot market and sell the same, at the same time, in the futures market. In effect, they hedge their investments. At the time of delivery, they profit from the spread in the future-spot market. Moreover, corporate actions such as dividend declaration, buy-backs, mergers or de-mergers also provide arbitrage opportunities in the futures-options markets.

The unique advantage of these funds is that though they buy stocks and futures in the equity markets, their strategy of simultaneous transactions in the spot and futures/options market make their returns neutral to the debt or equity market performance. The first arbitrage fund was launched just four years back by Benchmark. Currently, this category consists of just 14 funds. Though these funds are available for investment all the year through, its performance during this bear run has set them apart. This year, these funds have outperformed both the Sensex and the equity-diversified category by 34 and 40% respectively.

Arbitrage funds are ideal for risk-averse investors, who are absolutely averse to any depreciation in their capital. Moreover, these funds are more tax efficient than debt funds, as they are treated in line with equity funds. In comparison to all other variants of funds, arbitrage funds are the least volatile. The prime reason why investors are not drawn to these funds is because their returns are more or less in line with the debt funds. Hence, for any investor, the allocation to these funds would depend on their risk appetite. But ideally, it would always be prudent to allocate around 30 to 40% of one's fixed income portfolio to arbitrage funds.

Select Arbitrage Funds

ICICI Prudential Blended Plan A

The best performing fund in this category in 2006 came very close to repeating that feat in 2007. In the last two quarters, it has delivered a return of 4.75%. The financial services sector seems to be a favourite with the fund manager. One drawback of this fund is that it is not the most efficient in containing its cost.

JM Arbitrage Advantage

Overall the fund has been a solid performer by delivering above average returns. Currently, this fund is betting big on the construction sector and has allocated around 8% of its holdings to it. This may be due to the increased volatility, which this sector has seen in the recent months (as increased volatility creates more arbitrage opportunities).

A major concern is that its expenses are on a growing trend, an indication that the fund probably trades very heavily. While it is this very trading that tends to generate returns, the downside is that growing expenses eat into the returns.

Kotak Arbitrage Fund

Two factors stand out in favour of this fund. It has been a consistent player in this category and its expenses have always been on the lower side. In 2007, it turned in 9.06% and was ranked third in this category. But by and large, the fund's returns have rarely deviated from the category average. Average returns, consistency of performance and low returns are a plus for this fund.

UTI Spread

The sensation of 2008, it delivered 2.98 and 1.96% in the last two quarters, respectively. If one were to look only at this category, the fund has been an outperformer. But even if we were to broaden the horizon and include all the other categories, this fund will continue to stand out with a commendable performance.

In the last six months, this fund has decreased its equity holdings substantially to 0.60% (from 72% in December 2007). If it continues to maintain its current equity-debt allocation, then it would lose its status as an equity fund and would subsequently not be as tax efficient.

The author is CEO, Value Research