Arbitrage Funds: Do they work too hard for too little?   Aug 04, 2012

An edible oil wholesaler gave special discounts to all his customers who paid him in cash and took the delivery immediately. Many retailers took advantage of this offer thinking the discounts were attractive enough to settle dues in cash. However, there were a few retailers who paid no attention to the offer which looked attractive on the face of it. In reality, the wholesaler had strong connections with market insiders who tipped him off about the possible downtrend in prices over the next few months. He (the wholesaler) had booked his oil at a rate much cheaper than the one offered to his retailers. The special discounts lured retailers who believed the prices would remain firm. The condition of immediate delivery ensured that the stock with the wholesaler is cleared before he could take the delivery of newly ordered stock. However, some shrewd retailers had sensed the price downtrend and hence had refrained from placing orders straight off to opt for discounts. In a month’s time news of a possible bumper crop of oil seeds broke in the media and some bullish statements from the Agricultural Minister dragged the prices down. No longer could the wholesaler sell his old stock at higher prices as nobody would pay him at the old rates.

Mispricing of an asset is a profitmaking opportunity for those who know about the mispricing beforehand.

The Principle of Arbitrage Funds

The assets such as stocks or commodities are traded in different market segments, say Spot market and the Future Market. Spot market is nothing but the segment of market where the transactions happen on delivery basis and are settled on cash basis . Whereas, the Future is a contract entered by two parties to buy and sell a specified quantity of the stock (or any other asset) on some future date. The investor has to pay only a certain percentage of the total contract value upfront; which is called margin money. Arbitrage funds are a category of mutual funds which endeavours to take advantage of mispricing of stocks (or a stock index) in the different market segments. However, these are short term opportunities which spring up due to lack of information to a set of market participants in one of the markets. Over the period of time, the price differential evens off as these investors learn about the new developments. In this process, others such as arbitrage funds benefit by locking gains which are equal to the initial price differential.

Arbitrage Opportunities

Let’s understand how the arbitrage opportunities arise in the market with help of some real life examples.

As depicted in the chart below, on June 7, 2012, the S&P CNX Nifty in the Spot (cash) market traded at a discount to the Nifty Futures expiring on July 26, 2012. The disparity or the discount between the Spot and Futures market was on account of expectations of policy rate cuts by the central banks considering the cooling off of growth in India and China. Futures market, was optimistic about the outcome of re-elections in Greece and expectations of positive steps to be taken at European Summit towards the end of June by the European Central Bank (ECB) which was constantly under the pressure to provide the much required aid to Spain and Italy. But as the events unfolded the premium of S&P CNX Nifty in the Futures market started fading and on June 26, 2012 the prices in the Spot and Futures market converged.
 

Arbitrage Opportunity in Spot Nifty and Nifty Futures

(Source: ACE MF; PersonalFN Research)

Let us understand the strategy that an arbitrager would adopt under such circumstances.

As shown in the graph above; disparity between the prices of S&P CNX Nifty in Spot and Futures market, would have prompted an arbitrage fund to buy constituents of Nifty (in same weights as in the Nifty) on June 7, 2012 when Nifty was at 4,863.3 level and at the same time it would have sold Nifty Futures of equal amount expiring on July 26, 2012. On price convergence on June 26, 2012 (or when the price differential between the Spot and Futures market is at the minimum) the arbitrage fund would have reversed the positions in the trade to exit arbitrage. This is how the fund would have made 3.8% of riskless profits in just 20 days.

There are numerous such instances when the prices of the same asset can be different from one another in cash (spot) and the derivatives market. Within the derivatives market, two series of futures on the same underlying stock may deviate from each other on the same day. These can be treated as arbitrage opportunities in the most basic form virtually involving no risk.

Likewise, there are event based arbitrage opportunities which are not as canonic as mentioned above but they still give arbitragers opportunities to benefit from price differentials at minimal risk. For example, a stock that has announced hefty dividend may also be an arbitrage candidate if it is traded in the derivatives market. Such stocks could be volatile as the date of their going ex-dividend nears. Usually the stock prices reduce by the amount of dividend per share when the shares of the company go ex-dividend. There can be short-lived deviations in prices in the Spot and in the Futures market. Buyback or merger of a company, stock split are a few more such examples. Nevertheless, the principle remains same. Take counter balancing positions in two different markets and reverse the positions on price conversion or when prices are nearly the same.

Asset Allocation of Arbitrage Funds

The arbitrage funds are treated as equity oriented funds for the purpose of taxation and therefore they predominantly invest (about 2/3rd) of their assets in stocks presenting arbitrage opportunities and the rest are invested in debt and money market mutual funds. However, the funds can step up their investment in debt and cash in absence of adequate arbitrage opportunities. They are often promoted as a better alternative to money market mutual funds. Let’s see how they performed in reality.
 

Clearly, money market mutual funds have beaten arbitrage funds on important milestones. Over last 1 year the category of arbitrage funds has managed to generate 8.6% returns against which those generated by money market mutual funds look much superior. There is no comparison between the volatility exhibited by arbitrage funds collectively as it is nearly 6 times higher than that of money market mutual funds. Risk adjusted category average returns of money market mutual funds are almost 10 times higher than those generated by arbitrage funds.
 

However, over last 1 year, arbitrage funds managed to generate superior tax adjusted returns due to the favourable tax treatment they get. As said earlier, they are treated as equity oriented funds and any long term capital gains (when exited on completion of 1 year or thereafter) made through them are exempt from tax. Short term gains are charged to tax at the rate of 15%. On the other hand, money market funds are subject to tax. Short term capital gains are included in the gross total income of an investor and are taxed as per the tax slab of the assessee. Long term capital gains are charged to tax at 10% without indexation benefit and 20% with indexation. The excess post tax returns generated by arbitrage funds are too nominal to compensate investors for the level risks they are exposed to.

Reasons of Underperformance....
With advent of new technology and screen based trading platforms; market operations have become much transparent than they were two decades back. Transparency brings with it access to the real time prices of assets. This significantly reduces the occurrence of arbitrage opportunities. Furthermore, information affecting the stock prices is also available to investors in real time thanks to dedicated news channels and the websites covering financial markets 24X7. Social networking websites such as Twitter and Facebook have empowered even the smallest investors to receive and pass on the information in quick time. Web-blogs is another such medium. This is the biggest reason why meaningful arbitrage opportunities are difficult to find nowadays. Besides, there are a number of technicalities which make things difficult for arbitragers even if they come upon such opportunities. Let’s see with a help of an example;
 

Reverse Arbitrage Opportunities -A costly Affair

(Sources: NSE and PersonalFN Research)

As revealed by the chart above, S&P CNX Nifty presented arbitrage opportunity of 2% on May 4, 2012. The index was trading at a premium in the Spot market to its Futures. In other words, it means there were some unforeseen risks to the market which were recognised by the future traders but not by the spot traders giving rise to a meaningful price differential of 2%. The obvious strategy under these circumstances is to buy Nifty futures and sell Nifty in the spot market.

But there are restrictions on short selling. An institutional investor can’t sell anything in the cash market that he doesn’t own. However, there’s a way out. An arbitrager can borrow Nifty constituents under Security Lending and Borrowing Scheme (SLBS) for a maximum period of up to 12 months. These borrowed shares can then be short in the spot market. This doesn’t come free of cost. The borrower has to pay lender a fee for every single share he borrows. There are margin calls associated with it. Borrower needs to keep some permitted assets as collaterals. There is also a binding on mutual funds to restrict their derivative exposure to 50% of total assets. A spread of 2% therefore is not as lucrative as it looked initially. Furthermore, at times the price differential between Spot and Futures or between two different series of Futures can be nominal. Investment in risk free assets (such as T bills) could fetch you more than you earn in the arbitrage assuming prices converge only on the last day of the Futures’ series.

For example, March Futures of Reliance Industries (expiring on March 29, 2012) were trading at a discount of 0.9% to April Futures (expiring on April 26, 2012) on January 27, 2012. Assuming the difference between two series would last till the expiry of March futures series; arbitrager would have to assess the yields on risk free assets (if held for the similar time duration). He would also have to consider the costs associated with the trades and then take a call if the opportunity is worth entering. When the market volatility is low and the return on risk free assets are high; arbitrage opportunities would be difficult to find and vice-versa.

Another reason for underperformance of arbitrage funds is that they can’t exploit some arbitrage opportunities (even if they identify) due to complexities involved in executing them. Here’s an example
 

Speculation or Arbitrage?

Prices on Nasdaq are converted in INR using RBI reference rate as the exchange rate
(Sources: NSE, Nasdaq, RBI and PersonalFN Research)

Infosys is an Indian MNC which is listed on Nasdaq (U.S.A.) apart from being listed in India. Both markets operate in different time zones and therefore market timings differ too. As depicted by the chart above Infosys tumbled on Indian bourses on April 13, 2012 due to poor revenue guidance given by the company for Financial Year 2012-13. Indian markets had the information of subdued guidance given by the company but it could have not translated into profit as Nasdaq was close for real time trading. Short selling of shares on Nasdaq was an obvious trade next morning on Nasdaq however it could be difficult to judge for an Indian investor the quantum of fall and make counter balancing positions in advance to get upper hand. It could be otherwise a speculation or the pseudo arbitrage. Moreover, the same stock was traded in 2 different currencies which is always a risk because purchasing power of two currencies might not be the same at two different points of time and change in the stock prices may not be identical. Difficulty in trading at foreign market due to regulatory processes adds to complexities.

Our View

After having considered all the nitty-gritties of arbitrage funds; we believe they work too much for little extra returns. Success of Arbitrage Funds is contingent upon market volatility, risk free rate of returns and its ability to get access to real time market data. While market volatility and risk free returns are the factors that are beyond the control of the fund; access to real time data has become universal with advent of sophisticated trading platforms making meaningful arbitrage opportunities hard to find. This leaves them with little small margin for errors.

To add to their problems their expenses are high relative to their returns. The average expense ratio of arbitrage funds is about 1.37% which is extremely high compared to the category average of 0.67% recorded by money market funds. They charge an exit load if exited before the completion of specified time period. Furthermore, there have been instances in last 1 year where arbitrage funds have recorded losses on 15 day time period. This makes them a bad substitute to money market mutual funds. Investing in arbitrage funds just because they get a favourable tax treatment wouldn’t be a good idea either.

Why to invest in arbitrage funds if you need safety and liquidity? Liquid and liquid plus funds would do the job for you. In case your time horizon is more than a year; you may be better off investing in short term income funds. Those who have 3-5 years of time horizon should avoid investing in arbitrage funds as there are too many options available for you to neglect.

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