Arbitrage Funds

[mayurkotlikar]

I have been mostly investing in mutual funds via SIP.
After investing since last 3+ years now, I never experienced the terrible market fluctations since years.
Last 3 months, in few days, the market was climbing and dwindling down by 800 points in a day!!
Market is driven by sentiments, but this is way beyond what i evenr expected. I still remember watching many talk shows and many so called "experts" telling very confidantly that the SENSEX will reach 27000-28000 this year end. I cant say that this will happen or not, but still wonder whether it will reach 21,000 mark again this year. No doubt, staying for longer time, blah blah..etc works, but then, you might need a relatively stable investment option. Apart from Debt fund, I came to know about Arbitrage - funds just a few days back. I still believe in saving 70,000 annually in PPF as it is a best option, till the government backs it and gives 8% tax free.

Just wanted to share the "Arbitrage" stuff here, for those who are looking for a relatively stable returns with a relatively less risk. If anyone knows more about it, please add here.
<<Ref:ediff.com http://www.rediff.com/money/2006/sep/12mf.htm>>

-----------------------------------
Arbitrage is a strategy, which involves simultaneous purchase and sale of identical or equivalent instruments in two or more markets in order to benefit from a discrepancy in pricing. This strategy normally acts as a shield against market volatility as the buying and selling transactions offset each other.

[mayurkotlikar]

Recently UTI Mutual Fund and JM Mutual Fund have launched arbitrage funds, which will employ the arbitrage strategy of buying in cash and simultaneously selling in futures market.

In an arbitrage transaction, returns are calculated as the difference between the futures price and cash price at the time of the transaction. 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.

This arbitrage strategy makes the fund immune to market volatility i.e. the fund will not be affected by market fluctuations. 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 if the portfolio was unhedged i.e. these funds have a limited upside.

Despite the fact that arbitrage funds offer 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. That could be one reason why despite their equity holdings, arbitrage funds are benchmarked against indices like CRISIL Liquid Fund Index for want of a more appropriate index.

Apart from the strategies mentioned here, there are more complex derivative strategies, which can be used by mutual funds. The strategy would depend mainly on the prevailing market condition.

From the investor's perspective, investing in a mutual fund that dabbles in derivatives should not be considered as a sure shot way to generate/enhance returns.

While hedging and arbitrage strategies, when used effectively, can make the fund's portfolio immune to market volatility, using derivatives for speculation holds the possibility of converting the fund into a typical high risk -- high return investment proposition.