For income-tax savings, equity is best: Dividends from equity are tax-free. As investments, equities are volatile, with a risk of capital erosion. Arbitrage funds solve this problem by taking advantage of the mispricing between cash and derivatives markets, going long in the cash market and short in the futures market. This hedges the risk so that regardless of market movement, the returns are green. So while classified as equity funds, giving investors a tax benefit, arbitrage funds have exposure to debt. Yet their equity holdings are hedged, so the volatility associated with equity is missing.
Too good to be true? Well, arbitrage opportunities don’t come by often, margins tend to be low and expense ratios high (such funds trade heavily), and returns are not mindboggling. But despite the stock market debacle of 2008, these funds turned in 8.52% as a category that year. Measured against equity diversified funds (-55.08%), it stands tall. Compared to income funds (14.30%), it disappoints. Currently this category includes 16 funds. We take a closer look at three funds which boast superior performance.
Sandeep Bhatnagar / Mint
HDFC Arbitrage Retail
This fund’s trump card is its prowess in a falling market. In January 2008-May 2009, the market was in the red for 10 months. In eight of these, the fund outperformed the category average. Conversely, in the seven months the market closed in the green, the fund beat the category average in only four. This fund has a penchant for the financial sector, with an average allocation of 31.32%. The second preference, energy, lags (average allocation 10.80%). The fund has the lowest expense ratio in the category: - 0.83.
ICICI Prudential Blended Plan A
This one’s a mixed performer. In 2008, it comforted investors with a 9.25% return, third best in the category; in 2007, it was third from bottom. Over the last year, it has trimmed a bloated portfolio. In 2007, it averaged 60 stocks; now it’s down to 23. At all times, the portfolio was hedged by going short in the futures market. After September, it reorganized sector allocations, shifting towards defensive sectors such as fast moving consumer goods (FMCGs) and healthcare. It’s expense ratio (1.5%) is a bit high.
This was a category topper in 2008 (10.60%). From January 2008-May 2009, it outperformed the category average in 14 months, a reward for a bold stance that was often against the market trend. Since September 2007, there has been constant reduction in its equity allocation despite being more or less hedged at all times. This saved it from a fall in the equity market and it benefited from the debt rally of 2008. The icing on the cake: a low expense ratio of 1%.
Content by Value Research
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