Last week, UTI Mutual Fund launched what is quickly emerging as the next happy hunting ground for fund houses - arbitrage fund. It has joined the league of players that include Benchmark, JM Mutual Fund and Prudential ICICI [Get Quote] Mutual Fund, which have come out with arbitrage products in recent times.

Arbitrage is basically the simultaneous purchase of a stock and selling a futures contract in the same underlying asset in a bid to profit from the difference in price.

The equity markets offer an arbitrage opportunity primarily owing to inefficiencies in the market driven by sentiments or other technical factors.

At the heart of the arbitrage fund, thus, is the price difference between the spot and futures markets. For example, a fund manager buys 10,000 shares of company A at Rs 145.30 per share in the cash market on April 30.

Simultaneously, the fund manager gets into a futures contract for May to sell 10,000 shares of company A at Rs 146.50. The entire investment is thus hedged. And, if he maintains his position till expiry (and on the date of expiry, settles the futures position), he notches up an annualised return of about 9.9 per cent, not considering expenses and taxes.

The trading activity on the bourses shows that such price differentials are available all the time. On a steady trading day, about 20-25 of the 118 stocks on which derivatives trading is allowed offer a net arbitrage return of 8 per cent. In volatile markets, this can go up to 15-18 per cent. Plus this is a complete risk-free return.

For instance, for more than a month now markets have been hit by a substantial change in sentiments. The extreme volatility in the market and panic reaction to the sudden meltdown has thrown opportunities to make as much as 20 per cent with the future segment entering into steep discount to the cash market.

FIIs and cash-rich domestic traders have been quick to exploit this opportunity. Since the margin requirements to take positions in the derivatives are high, for small investors, the mutual fund route may be the best way to participate in such trading.

The performance of the three schemes currently in operation does not contradict this hypothesis. All the three schemes, which were positioned as a short-term debt funds and targeted investors who invest in six-month bank deposits or fixed maturity plans, outperformed the conventional debt funds in terms of returns (See table).

According to Biren Mehta, fund manager, JM Mutual Fund, "Arbitarage fund is virtually a risk-free product, completely hedged at all times and hardly impacted by the volatility in the markets."

"The derivative funds can engage in arbitrage activity up to 75-80 per cent of the asset size. We expect derivative funds to do well going forward. The volatility in these funds is not much since they don't take interest rate risks like in the case of debt funds," he adds.

The disadvantage of relying on mis-pricing of securities in different markets to generate returns is that investment opportunities may be few and difficult to spot and would require the fund managers to be very active.

Alternatively, simultaneous trade in various markets may increase transaction cost and high portfolio turnover rate, which could then eat into returns to unitholders. Also, as trading volumes increase, and more players track this space, the number of arbitrage opportunities-and returns-might reduce.

Another risk here is unlike traditional schemes, you can't exit freely, and payment doesn't always happen within 48 hours. The derivative fund punishes you for early exits, as it doesn't want to break its arbitrage positions mid-way to meet redemption needs.

In these funds, redemption is allowed on only one day in the month. So one should park only so much money that one can wait to withdraw.

It remains to be seen how investors react to arbitrage funds and what the fund managers concerned actually deliver over time. All said and done, this is indeed turning out to be a distinct product category.

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