How to use market volatility to your advantage

A year into equity investing, T Vishwanathan wants to make the most of the volatility in the equity markets.

He is looking at investing in one of the existing arbitrage funds.

"If the markets move up 200 points today, they could fall 100 points tomorrow. My investments will get affected unless I take advantage of this volatility," he says.

But as Akshay Gupta, CEO of Peerless Mutual Fund, points out, abitrage funds are opportunistic in nature and retail investors may not be equipped enough to spot the right time to enter and make the most of volatile market conditions.

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Arbitrage is a process of gaining from the spread between the cash and derivatives market or any two related mispriced assets.

In short, buying and selling stocks in future when there is a significant difference in the price of the stock in the cash market and in the futures contract.

Usually the stock price is lower in the cash segment as compared to the futures contract.

Buying in the cash segment and selling in futures allows you to profit from the price difference in both the segments, called spread.

Prior to the expiry date of the contract (the last Thursday of each month), this difference decreases and you can unwind your position booking profits.

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In terms of returns, arbitrage funds would thrive in a roller-coaster market.

So while the last one week saw the Bombay Stock Exchange Sensitive Index, or Sensex, losing 0.87 per cent and National Stock Exchange's Nifty 50 Index, or CNX Nifty, losing 1.21 per cent, arbitrage funds gave positive returns of 0.24 per cent, according to mutual fund rating agency Value Research.

In a period of one month, both Sensex and Nifty lost around 2.55 per cent, whereas arbitrage funds returned 0.85 per cent, as on November 30, 2010.

Arbitrage funds had their best annual returns during 2007 to 2008. Schemes such as ICICI Pru Blended Plan A-G returned 10.44 per cent in that period, JM Arbitrage Advantage gave 10.52 per cent and UTI SPrEAD 10.92 per cent.

In the last one year, ICICI Pru Blended Plan A-G has returned 5.34 per cent, JM Arbitrage Advantage 5.07 per cent and UTI SPrEAD gave the highest 4.18 per cent.

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Yet, despite the numbers, financial planners are not too sure if retail investors should dabble in this genre at all.

Says Anirudhha Hatwalne, a certified financial planner, "Yes, these funds fare better in volatile markets. But, investors neither understand the fund's concept nor the right time in the market to enter this segment.

Also, we can never say the market will remain volatile here on."

His advice: Retail investors should invest for the long term (3-5 years) and should not get affected by short-term market movements.

Gupta too recommends a debt fund over an arbitrage fund for retail investors.

"The gains from the spread between the cash and derivative segment are almost on a par or less than those in debt or money market funds," he says.

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Yet, if you want to experiment, you can enter such funds with a horizon of at least six months when the markets inch up in a bull run, adds Gupta.

Since arbitrage funds deal with derivatives, they are considered relatively safe while providing decent returns.

Derivatives are considered to be hedge instruments that protect the downside in a portfolio, almost like debt schemes.

Since the transaction - buy and sell - takes place immediately, there is no risk of holding the shares.

For the sake of experimenting, you can park up to five per cent of your portfolio in such funds, say experts.

The tax treatment of arbitrage funds is similar to that of equities.

If a person stays in the fund for more than one year, the returns are tax-free.

In case of redemption within a year, the person would need to pay a short-term capital gains tax of 15 per cent.