HDFC sec note mf category analysis - arbitrage funds - june 2015

RETAIL RESEARCH
Relatively better Performing Schemes from Arbitrage Category:
Scheme Name
Latest
Corpus
(RsCrs)*
Expense
Ratio
(%)
% of
allocation
into
equity*
Trailing Returns (%) Rolling Returns (%)
Standard
Deviation
(Monthly)
Exit Load
1
Month
Absolute
3
Month
Absolute
6
Month
Absolute
1
Year
CAGR
2
Year
CAGR
3
Year
CAGR
1
Month
Absolute
3
Month
Absolute
6
Month
Absolute
1
Year
CAGR
2
Year
CAGR
3
Year
CAGR
ICICI Pru Blended - A (G) 648 0.84 66% 0.58 2.22 4.52 8.17 8.83 9.15 0.73 2.19 4.43 9.17 8.77 8.25 0.17 0.50% before 3M
ICICI Pru Equity - Arbitrage (G) 2422 0.87 66% 0.6 2.31 4.71 8.44 8.99 9.41 0.73 2.19 4.42 9.12 8.69 8.17 0.18 0.25% before 1M
IDFC Arbitrage - A (G) 3287 1.00 65% 0.61 2.24 4.46 8.28 8.89 8.79 0.72 2.15 4.31 8.81 8.34 7.78 0.14 0.25% before 3M
Kotak Equity Arbitrage (G) 4168 0.93 56% 0.67 2.27 4.53 8.48 8.97 9.01 0.73 2.16 4.35 8.88 8.46 8.05 0.16 0.50% before 3M
Reliance Arbitrage Advantage (G) 1677 0.78 66% 0.66 2.66 5.15 8.78 9.01 9.17 0.75 2.23 4.46 9.13 9.31 9.28 0.26 0.25% before 3M
SBI Arbitrage Opportunities (G) 1008 1.22 66% 0.61 2.4 4.74 8.76 8.96 8.85 0.73 2.16 4.34 8.82 8.4 7.93 0.15 0.50% before 3M
Benchmark:
Average of Arbitrage Funds - 0.89 - 0.60 2.25 4.48 8.26 8.55 8.69 0.71 2.13 4.25 8.66 8.28 7.92 0.22 -
Average of Liquid Funds - 0.39 - 0.66 2.05 4.06 8.34 8.60 8.55 0.70 2.10 4.24 8.58 8.15 7.73 0.07 -
Average of Short Term Income - 0.97 - 0.64 1.84 3.81 8.97 8.56 8.98 0.74 2.25 4.56 9.06 8.52 8.42 0.45 -
Average of Ultra Short Term - 0.75 - 0.73 2.13 4.02 8.40 8.75 8.74 0.73 2.18 4.38 8.86 8.48 8.20 0.19 -
S&P BSE Sensex - - - -2.70 -6.72 -2.68 5.35 17.72 16.19 0.95 2.69 5.52 10.80 8.24 9.97 - -
CNX Nifty - - - -3.01 -7.33 -2.50 6.22 17.44 15.96 0.97 2.76 5.64 10.87 8.21 9.95 - -
Note: NAV values are as of June 15, 2015. Rolling Returns are calculated from the last 4 years NAV history. Standard Deviation (Monthly) is calculated from last 3 years data. * - as per the latest portfolio.
Summary:
 Arbitrage Funds are mutual Fund schemes which try to capitalize from the price differential of the same asset (stock/Index) between two markets or market
segments like between the cash and the futures markets.
 Arbitrage Funds score over liquid and other short-term income categories on the taxation perspective as they are categorized as equity oriented funds, enjoying
nil Long term capital gain tax after one year and nil Dividend Distribution Tax on the distributed income. Hence if the investor is looking for an investment
horizon of 1 year and above, he could opt for Growth option, else he should go for Dividend option.
 Arbitrage Funds are suitable for parking short term money for the period of 2 months and more and not for long term wealth creation. However given their
drawbacks like exit loads and mildly fluctuating returns in the short run, they give superior post tax returns compared to Liquid, Ultra short term, Short term
Income schemes. Like Short-term income funds, Arbitrage Funds can post negative returns in the very short term periods like one month and below. Further,
exit loads are applicable in most of the Arbitrage schemes if exited before 3 months (1 Month in some schemes).
RETAIL RESEARCH
June 22, 2015
Arbitrage Funds

RETAIL RESEARCH
 There are 17 schemes coming under the category whose AUM stood at Rs. 22,174 crore as on May 2015. The category witnessed a 300% growth in the last one
year period due to significant inflows into bonus option of the selected schemes to benefit out from the bonus stripping option. However, the AUM of the
category could fall going forward as AMFI has asked fund houses to discontinue bonus options.
 It seems to be tough phase for Arbitrage fund managers going forward due to the advanced technology and growing corpus: Arbitrage opportunity is eliminated
by the advancement in technology that enables the traders to monitor the fluctuations and act quickly to capture the mispricing occurring in the market. This
removes such opportunities in the matter of seconds. Further, growing AUM also makes it difficult for AMCs to convert the opportunity into returns.
 Apart from tax advantage, Arbitrage Funds deliver similar returns as compared to liquid and other short-term income funds. They do better during volatile
equity markets scenarios and above all, they have generated higher returns especially during down trends. The below chart portrays the same as it compares
the 3 month rolling returns (annualized) of the top performing schemes from Arbitrage category with Nifty. The chart shows the inverse relationship between
the schemes’ performance and the Nifty returns. The Arbitrage schemes perform better whenever there is a dip in the Nifty.
3 month Rolling Returns (Annualized) – Top performing Arbitrage schemes (LHS) Vs. Nifty (RHS):
Note: Rolling Returns calculated from the last 8 years NAV history.

RETAIL RESEARCH
What are the arbitrage strategies the Arbitrage Funds adopt?
What is Arbitrage Opportunity? In simple term, a difference between the stock price in the cash market and the futures market is referred to as an arbitrage
opportunity. In common, this difference arises due to inefficient flow of information between the two markets or differences in participants/regulation in two markets
and is temporary. More arbitrage opportunities are available when the markets are volatile.
When stocks are traded at relatively higher levels or when there is panic sales, the resultant higher volatility throws arbitrage opportunity by creating price difference
between cash and futures markets on stocks. Arbitrage schemes use hedging strategy of buying those stocks from the cash market and selling them in the futures
market in order to gain from the price difference.
The schemes may adopt some of arbitrage strategies like Index / Stock spot - Index / Stock Futures, ADR / GDR - underlying shares, hedging and alpha strategy, cash
futures arbitrage strategy and corporate action / event driven strategies. In the absence of adequate arbitrage opportunities, the schemes may invest in short term
debt or money market securities also.
How arbitrage works: Assume that the price of a stock is quoting at Rs. 500 in the cash market, whereas the price of stock in futures market is at Rs. 510. At this point,
an investor can make profit by selling a future contract of the stock at Rs. 510 and buying an equivalent number of shares in the equity market at Rs. 500. Thus, the
investor locks in profit of Rs. 10 per share on the day of settlement irrespective of price movement in any direction. Investment is the cost of cash stock and the margin
(initial and MTM) on futures sale. Profit is booked when, on the day of settlement, stock prices of both market segments coincide, and the investor can now reverse his
transaction - buy a contract in the futures market and sell off his equity holdings in the spot markets.
However, the returns generated by Arbitrage schemes mainly depend on the efficiency of the fund managers in spotting such opportunities and executing trades
efficiently to encash them.

RETAIL RESEARCH
The most common strategies that the fund managers adapt as follows;
1. Index Spot - Index Futures / Stock spot - Stock Futures:
 The pricing of the futures is derived from underlying Nifty spot or the underlying stock. It is the cost of carry that binds the value of the futures to the
underlying portfolio. When the two go out of sync, there are opportunities.
 The cost of carry binds the futures price to the price of the underlying asset. The price of the futures at any given instance should typically be more than the
level of Nifty at that point. Cash and carry trades at times provide higher than the prevailing interest rates. There is an opportunity to exploit by selling the
overpriced futures and buying the underlying portfolio. It may also happen that the Index / Stock Future may be at a discount. In such cases, the Scheme may
buy the future and sell the stock after borrowing the same, if it holds the stock. The Schemes shall enter into a combination of the transactions simultaneously.
 If the schemes have to unwind the positions prior to the expiry on account of redemptions or any other reason, the returns would depend on the spread
between the spot and futures price at which the position is unwound.
 If the price differential between the spot and futures position of the subsequent month maturity is attractive near the expiry date, then the scheme may
rollover the futures position and continue with the position in the spot market.
 The future contracts are settled based on the last half an hour’s weighted average trade of the cash market. Thus there is a convergence between the cash
market and the futures market on expiry. This convergence helps the fund to generate the arbitrage return locked in earlier. However, the position could even
be closed earlier in case the price differential is realized before expiry or better opportunities are available in other stocks. The strategy is attractive if this price
differential (post all costs) is higher than the investor’s cost-of capital.
2. ADR / GDR - underlying shares:
 Depository receipts can be converted into underlying domestic shares and local shares can be reconverted into depository receipts. The depository receipts
could either be Global Depository Receipts (GDRs) or American Depository Receipts (ADRs). GDRs are listed on the London or the Luxembourg Stock Exchange,
while ADRs are listed on the US exchanges like the New York Stock Exchange (NYSE) or the Nasdaq. Since every GDR / ADR has a given number of underlying
shares, the number of shares qualifying for reconversion into GDRs / ADRs is limited to the number of shares, which were converted into local shares.
 Say for instance that the ADR / GDR price is at a discount to the price of the underlying share. Converting the ADR / GDRs into the underlying shares can now
result in a gain. If the ADR / GDR price is at a premium to the price of the underlying shares, then it makes sense to re-convert the underlying shares into
depository receipts. All this is subject to headroom or the availability of shares for reconversion.

RETAIL RESEARCH
 Say for example a particular company has issued 10 million ADRs with one underlying share per ADR. Two million ADRs have been reconverted into local shares.
Therefore two million local shares can be converted to ADRs. Here the intention is to capture the spread due to mispricing in ADR/GDR and the equivalent local
shares, through simultaneous long or short positions.
3. Hedging and alpha strategy:
 The Arbitrage schemes use exchange-traded derivatives to hedge the equity portfolio. The fund managers shall either use index futures and options or stock
futures and options to hedge the stocks in the portfolio.
 The fund managers seek to generate alpha by superior stock selection and removing market risks by selling appropriate index. For example, one can seek to
generate positive alpha by buying an IT stock and selling CNXIT Index future or buying a bank stock and selling Bank Index futures or buying a stock and selling
the Nifty Index.
4. Corporate Action / Event Driven Strategies:
 a) Dividend Arbitrage: Around dividend declaration time, the stock futures / options market can provide a profitable opportunity. Generally, the stock price
decline by the dividend amount when the stock goes ex-dividend.
 b) Buy-Back Arbitrage: When the Company announces the buy-back of its own shares, there could be opportunities due to price differential in buyback price
and traded price.
 c) Merger: When the Company announces any merger, amalgamation, hive off, de-merger, etc, there could be opportunities due to price differential in the cash
and the derivative market.
Comparison of investment products with minimal risk:
Particular Arbitrage Funds
Short Term Debt Mutual Funds
Bank Fixed Deposits Taxable NCDs
Liquid & Ultra Short Term Funds Short Term Income Funds
Risk Very Low Very Low Low
Almost Nil, Deposits uptoRs.
1 lakh are
insured under DICGC
Medium
Investment Strategy
Capitalizing from the arbitrage
opportunity available in cash and
Future markets.
Benefiting by investing in very short
term debt instruments
debt instruments whose average
maturity
over the 3 years
used for banking activities
used for corporates' financial
activities
Tax applicable Yes Yes Yes Yes Yes
Tax on Income received
Since it is considered as equity
oriented schemes for the tax purpose,
dividends are exempted from tax. i.e,
Dividend received from Mutual Funds are tax free in the hands of investor.
However, on Debt mutual funds, the AMC deducts and pays
28.84% (including sur-charge &cess) from the distributable dividend for
Taxable as per income tax
slabs
Taxable as per income tax slabs

RETAIL RESEARCH
Risk Parameters: Standard Deviation
As seen in the above chart, the risk as measured by the Standard Deviation (calculated based on
the Annualized returns from the last 3 years NAV data) of the Arbitrage category is positioned
above Liquid and Ultra Short term categories.
No DDT. individual investors
Tax on Growth option of Mutual Funds
Long Term Capital Gain applicable
After one year from the date of
purchase.
After three years from the date of purchase.
NA. However, proceeds are
taxable as per income tax
slabs.
After one year from the date of
purchase.
Long Term Capital Gain Tax
Nil. Since it is considered as equity
oriented schemes for the taxation
perspective, such gains are exempted
from tax
Long Term Capital Gain Tax applicable for the redemption made after three
years as levied 20% with indexation on the gain.
NA
Long Term Capital Gain Tax
applicable for the redemption
made after one year as levied
10% flat.
Short Term Capital Gain Tax
Short Term Capital Gain is applicable
if the units are sold before one year
and the tax is levied at the rate of
15%.
Short Term Capital Gain Tax is applicable if the units are sold before three years
and levied as per the investors’ tax slabs up to 33%.
NA
Short Term Capital Gain Tax is
applicable if the units are sold
before one year and levied as
per the investors’ tax slabs up to
33%.
Arbitrage Vs. Other Short term Income categories:
Arbitrage Category vs. Short term Income categories– in various time frames:
The above chart shows the equivalent performance posted by the Arbitrage category in
comparison to the Liquid funds category. Though the Arbitrage category posted similar returns
over the longer term periods such as one, two and three years, the category outperformed not
only liquid schemes but also ultra short term and short term income funds in 3 & 6 months
period.

RETAIL RESEARCH
Top performing schemes from the category:
Reliance Arbitrage Advantage scores among the top performing schemes followed by ICICI Pru
Equity Arbitrage and SBI Arbitrage Opportunities.
Options break-up in the Corpus:
Rolling Returns performance:
Arbitrage Funds and Other Short Term Income Funds posted almost similar returns during all the
periods as far as the rolling returns are concerned.
Corpus Growth of Arbitrage Funds:

RETAIL RESEARCH
Corpus:
The Arbitrage category witnessed a 300% growth in the last one year period due to significant inflows into bonus option of the selected schemes to benefit out from
the bonus stripping. However, the AUM of the category could fall going forward as AMFI has asked fund houses to discontinue bonus options. Notable fund flows into
bonus option witnessed started post July 2014 as there was a change in the taxation for debt mutual funds as an increased time frame to three years from one year was
prescribed to avail the Long Term Capital Gain benefit. Funds like JM Arbitrage Advantage Fund, Religare Invesco Arbitrage Fund, AXIS Enhanced Arbitrage Fund
witnessed huge fund flows especially in bonus options to benefit out from bonus stripping tax advantage.
Dividend History of the selected schemes from Arbitrage category: Most of the schemes declare dividend on monthly basis.
Scheme Name Record Date Gross (%)
Ex-Dividend
Date
Scheme Name Record Date Gross (%) Ex-Dividend Date
ICICI Pru Blended - Plan A (D) 5/15/2015 0.76 5/18/2015 Kotak Equity Arbitrage Fund (Div-BiMthly) 5/25/2015 3.41 5/26/2015
ICICI Pru Blended - Plan A (D) 1/30/2015 1.17 2/2/2015 Kotak Equity Arbitrage Fund (Div-M) 5/25/2015 1.01 5/26/2015
ICICI Pru Equity - Arbitrage Fund (D) 5/15/2015 0.74 5/18/2015 Kotak Equity Arbitrage Fund (Div-M) 9/22/2014 0.64 9/23/2014
ICICI Pru Equity - Arbitrage Fund (D) 1/30/2015 1.25 2/2/2015 Reliance Arbitrage Advantage Fund (D) 3/23/2015 4.00 3/24/2015
ICICI Pru Equity - Arbitrage Fund (D) 12/26/2014 0.78 12/29/2014 Reliance Arbitrage Advantage Fund (D) 11/25/2014 1.50 11/26/2014
ICICI Pru Equity - Arbitrage Fund (D) 11/28/2014 0.54 12/1/2014 Reliance Arbitrage Advantage Fund (Div-M) 5/25/2015 0.50 5/26/2015
IDFC Arbitrage - Plan A (D) 5/28/2015 1.04 5/29/2015 Reliance Arbitrage Advantage Fund (Div-M) 9/22/2014 0.60 9/23/2014
IDFC Arbitrage - Plan A (D) 4/29/2015 0.80 4/30/2015 Reliance Arbitrage Advantage Fund (Div-M) 8/25/2014 0.60 8/26/2014
IDFC Arbitrage - Plan A (D) 3/25/2015 0.80 3/26/2015 SBI Arbitrage Opportunities Fund (D) 5/29/2015 0.70 5/29/2015

RETAIL RESEARCH
SBI Arbitrage Opportunities Fund (D) 7/30/2014 0.70 7/30/2014
SBI Arbitrage Opportunities Fund (D) 6/25/2014 0.70 6/25/2014
Analyst: Dhuraivel Gunasekaran (dhuraivel.gunasekaran@hdfcsec.com) Source: NAVIndia & ACEMF
RETAIL RESEARCH Tel: (022) 3075 3400 Fax: (022) 2496 5066 Corporate Office
HDFC securities Limited, I Think Techno Campus, Building - B, "Alpha", Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Phone: (022) 3075 3400 Fax: (022) 2496 5066 Website:
www.hdfcsec.com Email: hdfcsecretailresearch@hdfcsec.com
Disclaimer: Mutual Funds investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared by HDFC Securities Limited and is meant for sole use by the recipient and not for
circulation. This document is not to be reported or copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed
reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or
perform investment banking, or other services for, any company mentioned in this document. This report is intended for non-Institutional Clients
This report has been prepared by the Retail Research team of HDFC Securities Ltd. The views, opinions, estimates, ratings, target price, entry prices and/or other parameters mentioned in this document may or may not match or may be
contrary with those of the other Research teams (Institutional, PCG) of HDFC Securities Ltd.

HDFC sec note mf category analysis - arbitrage funds - june 2015

More Related Content

What's hot

Similar to HDFC sec note mf category analysis - arbitrage funds - june 2015

More from Dhuraivel Gunasekaran

HDFC sec note mf category analysis - arbitrage funds - june 2015