JM Arbitrage Advantage Fund (JMAAF) is another offering in the league of funds that are trying to capitalise on the opportunities in the derivatives segment. JMAAF is an open-ended equity-oriented fund and the second arbitrage fund from JM Financial Mutual Fund (earlier they had launched the JM Equity and Derivatives Fund). The fund offers investors the proposition of capitalising on arbitrage opportunities arising out of mis-pricing in the cash and derivatives markets.
Arbitrage is a strategy, which involves simultaneous purchase and sale of identical or equivalent instruments from two or more markets in order to benefit from a discrepancy in their prices. This strategy normally acts as a shield against market volatility as both buying and selling transactions offset each other. In the Indian context arbitrage is largely concentrated in stock futures; index arbitrage is not very popular as yet.
JMAAF will use the arbitrage strategy of simultaneously buying stocks in the cash market and selling futures contracts of the same company. This kind of arbitrage opportunity arises for instance when the prices in futures market are higher than that in the cash market. This usually prevails when the sentiment is bullish; in a bearish market such opportunities become difficult to spot.
In an arbitrage transaction, returns are calculated as the difference between the futures price and cash price at the time when the transaction is entered into. Ideally the positions are held till the expiry of the futures contract when the offsetting positions cancel each other and initial price difference is realised. Being completely hedged at most times can make JMAAF a low risk investment proposition; also, it is unlikely to be affected by the turbulence in the stock market.
Apart from the arbitrage proposition, there are other important features of JMAAF that merit a closer look. Being an arbitrage fund, it will rely heavily on mis-pricing of securities in the cash and futures markets. It might well be that the mis-pricing opportunities are few and difficult to spot; it will require a very active fund manager to spot these limited opportunities. Also simultaneous trades in different markets increases the transaction cost considerably; this could have an adverse impact on the returns of the fund.
Liquidity is another matter of concern. JMAAF allows redemption only once a month. Redemptions will be permitted on the Friday preceding the last Thursday of every month (last Thursday of every month being the settlement day or expiry day of derivatives contract). Thus unlike conventional open-ended equity funds, investors' ability to liquidate their investments will be restricted.
Though JMAAF offers investors the opportunity to benefit from investments in equities by making use of derivatives, the fund cannot be compared to conventional diversified equity funds, especially on the returns parameter. The returns from arbitrage funds would typically be much lower than those of equity funds (over a three year investment horizon). Since the portfolio of arbitrage funds is completely hedged at all times to lower the risk of loss/erosion of gains, it also in turn caps the returns that the fund could have clocked.
Given the fund's investment style and flexibility it is difficult to slot JMAAF for a particular investor category. Till the time the fund invests exclusively to exploit arbitrage opportunities in cash and futures markets, it will fit into the low risk investor's investment profile. However, the fund admits that it may not have sufficient arbitrage opportunities at all times and may invest in equity markets like a conventional equity fund. In such a scenario, the risk of investing in the fund will increase considerably given that it will no longer be just an arbitrage fund.
