NFO Pick – (Motilal Oswal Arbitrage Fund)

16 Dec 2024 , 10:28 AM

ARBITRAGE FUNDS – WHAT EXACTLY IS ARBITRAGE?

The term arbitrage refers to the price differential between two similar assets across two different markets. That means, if a similar asset is priced lower in one market and higher in the other market, then you buy in the first market and sell in the second market. The price differential becomes your assured return, irrespective of where the market price eventually ends up. There are different type of arbitrages available, and here are some examples.

• You can buy the same stock on the NSE and sell on BSE or vice versa to lock difference.
• You can buy in the commodity market and sell same quantity in commodity futures.
• You can buy in the cash market and sell same quantity in stock futures
• You can do a basket arbitrage by index stocks and selling proportionate index futures
• Finally, there are complex statistical arbitrages, merger arbitrages, convertibles etc.

While all these are technically available, cash / futures is the most popular in India. An arbitrage fund is a mutual fund scheme that uses its corpus to create such arbitrage opportunities in the market and makes the best of such short term opportunities.

HOW THE ARBITRAGE TRANSACTION WORKS IN PRACTICE

Let us talk about cash-futures arbitrage which is the most popular. Let us take the case of Adani Ports. It is trading at ₹1,259 in Spot and ₹1,271 in January Futures. We ignore December futures as there are only 10 days to expiry. This gives us an arbitrage profit of ₹12 for 45 days, which translates into annualized returns of 7.73%. That is an attractive return for an arbitrage as it mirrors a liquid fund or short term debt fund returns and is almost considered risk free. Since the lot size is 400 shares, you must at least buy 400 shares of Adani Ports and sell 1 lot against. In reality, institutions trade in much bigger order sizes.

On the day of expiry on January 30, 2024, if the price of the spot and futures settle at ₹1,300, then the arbitrageur makes a profit of ₹41 on the cash position and makes a loss of ₹29 on the futures position. The net profit is ₹12. This arbitrage profit of ₹12 remains constant, irrespective of the closing price of Adani Ports. How is this profit realized? One way is to reverse the arbitrage transaction i.e. sell the stock and buy back the futures. However, the more common method is to hold on the cash position and keep rolling over the short futures position. Each month, the positive spread on futures short roll accrues to the arbitrage fund in the form of arbitrage profits.

DO ARBITRAGE FUNDS DELIVER THE GOODS?

Let us compare the historic performance of arbitrage performance with that of liquid funds and ultra short term debt funds. One of the major reasons for the outperformance of arbitrage funds is the favourable tax treatment. For example, if you take a short term debt and an arbitrage fund with a pre-tax return of 7.5%, the arbitrage fund has an advantage in post-tax returns to the tune of 75 bps to 130 bps across different time frames.

If you compare on the rolling returns net of costs and surcharge, then arbitrage fund have delivered annualized alpha of 117 basis points over liquid funds and an alpha of 98 basis points over ultra short term debt funds. However, as we mentioned earlier, the arbitrage fund do best in bursts when volatility is high in the market; like in the last one year, when arbitrage fund have generated higher alpha. Hence strategic asset allocation of short term funds will really work in case of arbitrage funds.

WHY TO INVEST IN MOTILAL OSWAL ARBITRAGE FUND

The Motilal Oswal Arbitrage Fund brings several generic and specific advantages to the table. Let us first look at the generic advantages. Like any cash-futures arbitrage fund, this fund is also low risk and market neutral in its positioning. In recent quarters, arbitrage funds have emerged as a serious and viable alternative to liquid funds and ultra short term debt funds. The arbitrage funds are also very liquid and can be liquidated at short notice. However, here it must be noted that bunching of arbitrage reversals can add to the market volatility. Tax efficiency is a big advantage, of course.

Let us now turn to some specific advantages that the Motilal Oswal Arbitrage Fund has. It will maintain 65% minimum exposure to equity, so it will continue to be classified as an equity fund for tax purposes. More importantly, the Motilal Oswal Arbitrage Fund will not charge management fees for 12 months for direct plans. What will be the impact? The average segment TER of 33 bps goes away for a year. Assuming 7 bps expense ratio and management fee waived, the return advantage in this fund would be around 26 bps, making it among the top performers.

The Motilal Oswal Arbitrage Fund is best suited for the risk averse investor looking at stable income. Above all, it can also be a boon for institutions and corporates looking for higher returns with liquidity as well as HNIs looking at tax efficiency.

HOW ARBITRAGE FUNDS PERFORMED IN INDIA?

The Motilal Oswal Arbitrage Fund is an arbitrage fund NFO (classified by AMFI as hybrid funds) focusing on long-cash and short-futures to capture arbitrage opportunities. While these are classified as equity fund for tax purpose, they are effectively like liquid or short term debt funds. There are a total of 27 Arbitrage funds active in India.

Scheme Name	Return (%) 1-Year	Return (%) 3-Years	Return (%) 5-Years	Daily AUM (₹ in Crore)
Kotak Equity Arbitrage Fund	8.66	7.17	6.16	54,824.65
Edelweiss Arbitrage Fund	8.58	7.10	6.20	11,972.76
Tata Arbitrage Fund	8.52	7.01	6.25	12,583.56
Bandhan Arbitrage Fund	8.49	6.96	5.92	7,419.94
Mirae Asset Arbitrage Fund	8.49	6.95	N.A.	2,981.08
Aditya Birla Sun Life Arbitrage Fund	8.48	6.94	5.99	13,771.93
Invesco India Arbitrage Fund	8.47	7.38	6.22	18,036.14
ICICI Prudential Equity Arbitrage Fund	8.44	6.89	5.95	24,212.51
UTI Arbitrage Fund	8.42	6.85	5.96	6,544.42
Nippon India Arbitrage Fund	8.41	6.96	6.07	15,130.37

Data Source: AMFI

The table provides the performance of top 10 arbitrage funds on 1-year returns. Considering the short term nature of arbitrage funds, 1-year returns are used to rank them. Arbitrage Funds in India have a total AUM of ₹2,51,388 Crore overall. Returns beyond 1 year are CAGR returns and arbitrage funds have become very popular of late. Here are the average returns.

• On a 1-year returns basis, Arbitrage Funds generated maximum returns of 8.58% and minimum returns of 7.23%. The average returns over a 1-year period was 8.23%, which is fairly impressive considering its tax efficiency.
• On a 3-year CAGR returns basis, Arbitrage Funds generated maximum returns of 7.38% and minimum returns of 5.88%. The average returns over a 3-year period was 6.75%, which shows relatively higher degree of variance.
• Over a 5-year CAGR period, Quant Funds generated maximum returns of 6.25% and minimum returns of 4.89%. The average CAGR returns were 5.79%.

Arbitrage funds are benchmarked to the Nifty Arbitrage TRI. One quick observation is that these arbitrage funds do better in specific periods, like when volatility and spreads are higher; as in the last one year. Hence strategic asset allocation will work for these funds.

GLANCE AT THE MOTILAL OSWAL ARBITRAGE FUND NFO

Here are key details of the Motilal Oswal Arbitrage Fund NFO.

• The NFO open on December 16, 2024 and closes on December 19, 2024. Being an open ended fund, the sale and repurchase at NAV-linked prices start within a week.
• On the risk-o-meter, the Motilal Oswal Arbitrage Fund is classified as a Low Risk fund due to its predominant structure that resembles a short term liquid fund. It purely uses long equity and short futures to replicate an assured return arbitrage situation.
• The investment objective of the fund is to lock into arbitrage opportunities so as to create alpha. It is benchmarked to the Nifty 50 Arbitrage TRI, but the returns of Arbitrage Funds are normally compared with liquid funds and debt funds.
• There will be no entry load on this fund. However, there will be an exit load of 0.25% on redemptions or switch-outs made before 30 days from the date of allotment. For redemptions after 30 days from the date of allotment, there is no exit load. Arbitrate funds are normally short term products, where strategic asset allocation can help.
• The Motilal Oswal Arbitrage Fund will offer regular and direct plans. In terms of the options, the fund offers the growth and the IDCW plan to investors.
• Ajay Khandelwal, Atul Mehra, and Niket Shah will be the fund managers for the Motilal Oswal Arbitrage Fund, and will be assisted by a team of multi-disciplinary specialists.
• The minimum investment amount in the NFO will be ₹500 and multiples of ₹1 thereof. Redemptions can also be done in minimum size of ₹500 and in multiples of ₹1, subject to the availability of account balance in the mutual fund account.
• With over 65% exposure to equities, Motilal Oswal Arbitrage Fund will be classified as an equity fund for tax purposes. Under the new tax rules effective from July 23, 2024; short term gains (held for less than 12 months) will be taxed at 20% plus cess; while long term gains (held for over 12 months) are taxed at 12.5%, with ₹1.25 lakhs base exemption.

The Motilal Oswal Arbitrage Fund offers a good alternative to liquid funds and debt funds, with an element of market risk, but also the advantage of preferential tax treatment.