Mirae Asset has launched an NFO (New Fund Offering) for its Arbitrage Fund. The NFO is open from 3rd to 12th June 2020. We took a look to see if it makes sense for investors.
Short Answer: Recent concerns about the category notwithstanding, Arbitrage funds are relatively tax-efficient instruments to park money for periods longer than 6 months. However, there is significant variation in how arbitrage funds have performed. We pick a combination of two direct funds, with low expenses, and a consistent track record of delivering returns close to or above the NIFTY 50 Arbitrage Index.
Read on for our detailed review.
“Arbitrage” funds? That sounds shady
First, an irrelevant but hopefully interesting detour. Or you could just skip this paragraph.
In corporate America of the 1980’s, LBOs (Leveraged BuyOuts) were the flavour of the times. An LBO, was a mechanism for someone, anyone, to finance the cost of an acquisition using debt. The best thing about LBOs, for ambitious acquirers was, you raised debt against the cashflows from the assets of the target company. Now, conservatively valued debt would not let you raise enough money to buy iconic companies with rock-solid businesses. So you raised debt at crazy yields. Also called Junk Bonds.
Now anyone could make a play for big established listed companies. Buy some of the company’s stock. Raise financing by issuing junk bonds at insane yields, and use that financing to make an offer at a premium. One of the most celebrated LBOs of the times was the $25 Billion KKR buyout of RJR Nabisco. A corporate takeover so hotly followed, it was the subject of a Time magazine cover with the then-CEO Ross Johnson’s picture under the caption “A game of greed”.
In an environment where just about any company could become the target of a hostile takeover, a new breed of asset manager emerged, called merger arbitrageurs.
On paper, a merger arbitrage involves selling (shorting) stock of one and buying the other company involved in a merger or takeover. In reality, arbitrageurs of the 1980’s became central nodes in networks of illegal insider information. Building massive positions in companies that were about to become takeover targets based on carefully cultivated sources in investment banks working with potential acquirers. This went on for a while before a bunch of high-profile arrests led by then Attorney General Rudy Guilliani brought the party to a close. That was just the end of this most egregious form of market manipulation.
Track the stock price of any Indian company a few days before major corporate announcements and there won’t be doubts about whether insider trading ended in the 1980s.
In case it wasn’t clear, the above history lesson has NOTHING to do with Arbitrage Mutual Funds.
So, what are arbitrage funds…Really?
Here’s Mirae Arbitrage Fund’s stated Investment Objective from the NFO document:
The investment objective of the scheme is to generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and derivative segments of the equity markets and the arbitrage opportunities available within the derivative segment and by investing the balance in debt and money market instruments.
The Scheme proposes to invest in equity and equity related instruments by identifying and exploiting price discrepancies in cash and derivative segments of the market.
This sounds vague, exotic and therefore risky. It is not.
I needed it explained to me like I’m 5. Something like this:
As of writing this after close on 5th June, BHARTIARTL stock closed at 581.30
Now look at the closing prices of Airtel’s June, July and August Futures.
All upwards of 584, with Aug Futures showing the highest price.
Think of futures prices being what the market “expects” BHARTIARTL stock to be at the end of June, July and Aug respectively i.e. in the Future. Longer the time frame, higher uncertainty, and therefore the ₹ 4 / share difference from the August Future price, while only ₹ 2.95 / share difference from the June price.
As we move toward the end of June, the price of the stock and that of the June Future will get closer. Why? The “future” price of Bharti Airtel has to become the “current” price with the passage of time. This could be the future moving down to meet the current price, the other way around, or both moving down or up, but one more than the other to bridge that gap. This is inevitable except when there is no liquidity. This did happen in March [How a global liquidity crisis beat us before the coronavirus].
An arbitrage fund manger would buy the stock, and sell the future short. As the gap closes, one gains while the other loses, but the difference in the gain and the loss will be net positive and hence “arbitrage return”.
Expected Returns from Arbitrage Funds
You don’t need to be a student of finance to guess that a strategy that generates almost certain returns is either a scam, or will only generate returns close to the risk-free rate.
Chart shows the NIFTY 50 Arbitrage Index – the benchmark for arbitrage funds, including the Mirae Arbitrage Fund.
The benchmark NIFTY 50 Arbitrage Index has returned a steady 6.52% over 10 years. Which happens to be almost how much the NIFTY has appreciated in the same time. Of course, you have to add on the 1.5 – 2% dividend yield of the NIFTY.
How do Arbitrage Funds compare with the benchmark?
Table below shows median returns from Arbitrage funds over 1, 3 and 5 year time frames.
Overall, Direct arbitrage funds just about beat their benchmark. That’s an encouraging sign.
If it still needs to be said, the invisible 0.64% distributor commission regular funds charge almost entirely explains the difference between annualised performance of Direct and Regular.
Keep Costs low. Buy Direct Mutual Funds.
All Arbitrage Funds are not the same
Chart shows the distribution of individual fund annualised returns over the last 1, 3 and 5 years. Each dot is a fund. Purple dots represent the category return.
Though most funds are clustered around the median, especially over 3 and 5 years, there are a few negative outliers that have delivered only half the category return.
These negative outliers, or “problem” funds you see on the left of the chart are run by Principal, Essel and JM. Definitely steer clear of those.
Given the category is ideally suited to safely hold money for periods of 6 months and up, the choice of Arbitrage fund should be similar to how you would choose a liquid fund, or a savings bank. Track record and Safety over an additional 10 or 20 basis points of return.
Liquid Funds vs Arbitrage Funds
Both Liquid and Arbitrage Funds have delivered similar median returns. So why not just liquid funds?
It comes down to the taxation tie-breaker:
Arbitrage funds are treated as Equity Mutual Funds i.e. Short-Term Capital Gains apply until a year and are taxed at 15% (irrespective of your tax slab).
Liquid Funds are Debt funds. Short-Term gains apply for 3 years. Which wouldn’t be a problem for short-term holdings, except, the income from liquid funds is considered as “Other Income” and gets taxed at your slab Income Tax rate, which is investor-specific can be as high as 42.7%. [Where should I park money for the short-term?]
What about the recent concern about Arbitrage Funds?
Last week, some fund houses warned investors of poor or negative near-term returns from Arbitrage funds.
Kotak Mutual Funds issues warning on arbitrage spreads [1st June, livemint]
Near-term loss in arbitrage schemes likely: MFs [4th June, Economic Times]
Is there enough reason to stay away from this category?
We don’t think so.
The current situation seems to have been because of a perfect storm of lots of money coming into arbitrage funds leading to downward pressure on futures prices narrowing spreads between spot and futures and reducing opportunities available. The chances that they will actually lose money over a 6+ month timeframe, seem remote (never say never though).
The Risk in Arb Funds
While arb funds should generally be low risk, the issue can get complex because of mark-to-market requirements, and size.
Today, Arb funds have a total size of roughly Rs. 71,000 cr. in AUM. The total open interest in the futures market is Rs. 91,000 cr. Assuming Arb fund put 65% of money into stock futures (and stocks) that’s roughly 46,000 cr. in stock futures.
In fact, since March 31, nearly Rs. 19,000 cr. has been added to arb funds overall!
Half the futures market is now with arb funds. This is a risk because the size makes them vulnerable.
We’ll write a separate post on this, but there is a risk if:
a) there is a sudden and large withdrawal of money by investors in Arb funds, which will cause a big spike in arbitrage spreads. Current spreads are averaging under 4%. (This is because, exiting from the arb fund will result in their crystallizing losses for all investors when they unwind positions at higher spreads than they entered)
b) There is an extreme movement in the market that can rapidly spike up margin requirements, which may require the arb fund managers to reduce their positions in order to meet margin calls. This is unlikely, but still a risk.
Basically the risk are “tail risks”. You can’t foresee them because they will only happen in the case of an extreme situation. However, given we are in an extreme situation right now in other areas (lockdowns, Covid etc), it’s only right that we warn you that arbitrage funds aren’t exactly risk free.
For those in higher tax brackets, Arbitrage Funds are relatively tax-efficient compared to other short-term investment options. They can sometimes show higher volatility in periods shorter than 6 months but they have low risk of loss of capital, the only risk that should matter for safe short-term instruments.
Unless a mutual fund is investing in a new and compelling strategy, it makes sense to look for a track record before investing. Currently there are ten funds with track records over 5 years and AUM over 1,000 Crores. We’d pick one of those over the new Mirae Arbitrage Fund. After it’s been around for a 3 years, it can make it to your shortlist on the basis of performance.
Our recommendation for parking funds for the short-term is to pick two of the funds in the above table. Details on the Capitalmind Answers Page [Premium Access Required].
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