The sharp drawdown in portfolio values since this January has seen a paradigm shift in investor behaviour. Even portfolios with equity bias now seem to prefer exposure to assets with stable returns.
Some investors, for instance, have taken exposure to arbitrage funds (arb funds) as they have generated positive returns even during market downturns. Do such funds provide optimal gains?
Academic arbitrage is riskless. It involves buying an asset in one market and selling it in another for a higher price without initial investment.
Financial markets do not provide such opportunities. Some risk is involved because an initial capital outlay is often required. But the strategies that arb funds engage in are the closest an investor can get to riskless arbitrage.
The concept is based on capturing the “cost of carry” in the futures price.
Take Reliance Industries. Suppose the current spot price is Rs 1,200 and the near-month futures contract trades at Rs 1,215. The portfolio manager will buy, say, 7,500 shares of Reliance and sell 100 contracts (underlying 75 shares) of near-month futures.
The trading strategy is built on the fact that futures price converges to the spot price on expiry. What if Reliance spot price is at Rs 1,350 on expiry? The portfolio will gain Rs 11.25 lakh in the spot market but lose Rs 10.12 lakh in the futures market.
The net gain on the spot-futures arbitrage will be Rs 1.125 lakh.
What if Reliance closes at Rs 1,100 in the spot market? The portfolio will lose Rs 7.5 lakh in the spot market but gain Rs 8.625 lakh in the futures market.
The net gain will be Rs 1.125 lakh. The gain is the difference between the futures and the spot price at the time the trade is initiated.
It is, however, not necessary for the portfolio manager to hold the position till expiry. If she finds that the difference has narrowed since initiating the trade, she can close the position and capture arbitrage gains.
The portfolio will, however, gain most if the position is held till expiry. The reason is that the difference between futures and spot price will then be zero and the initial difference turns into arbitrage gains.
Arb funds generated between 7 and 8 per cent return in the last one year. The benchmark for such funds is typically a liquid index.
Money market funds have generated higher returns this year because of the tight liquidity in the credit market.
Such funds invest in short-term instruments such as treasury bills and commercial papers.
Liquid funds are somewhat different in that they also invest in short-term bonds.
The point is that upside is capped in money market funds as returns comprise only of interest income.
Liquid funds generate marginally higher returns but are exposed to price risk due to bond price declines.
Arb funds carry the potential to generate higher returns if there is large mispricing in assets, which is often the case in volatile markets. Besides, such funds neutralise market risk as long as the portfolio manager follows the fund’s mandate.
This gives the fund an alpha-like characteristic which fits well in the satellite portfolio within the core-satellite framework. Alpha returns refer to excess returns that the fund manager generates which has low correlation with market returns.
Investors have to consider two factors before choosing an arb fund- management expense ratio (MER) and exposure to the bond market. Most arb funds have MER between one and 1.65 per cent. This is high but not unreasonable, considering that even index funds carry an MER of one per cent.
The problem then is with the arb fund’s bond exposure. Arb funds take such exposure to earn above cash-returns when the portfolio manager does not find arbitrage opportunities.
Investors should prefer funds instead that take exposure in money market instruments. The reason is that bonds carry higher price risk that may not be necessarily compensated by the higher yield.
Besides, such exposure could bring down the stability of alpha returns, as exposure to bond market will increase correlation with market returns.
The continual decline in asset prices has led many investors to look for exposure that provide relatively stable returns. This article shows why arb funds could be one such exposure. At present, there are just over 10 funds exploiting the spot-futures arbitrage.
As more funds engage in such strategies, arbitrage gains may become increasingly difficult but not impossible. Till then, MERs and bond exposure will play a significant role in selecting an arb fund.
B. Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)
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