The equity markets have been extremely volatile lately, while the bond markets aren’t safe either. In fact, it has made investors jittery. With both the prime asset classes being uncertain, is there a way out for the investors?
However, it is noteworthy that the equity markets are showing some green shoots in terms of attractive valuations in the non-large cap domain. The probability of looming volatility cannot be ruled out, as all eyes are on the upcoming budget. Only way to unlock the potential of volatility would be through arbitrage opportunities by launching an arbitrage fund.
An arbitrage fund is a sub-category of Hybrid fund that seeks opportunities from differential pricing in two different segments (spot and futures or cash and derivatives) of the equity market. Such opportunities are usually tapped in volatile market conditions.
Typically, an arbitrage fund is less risky than the pure equity fund because participants are not speculating on market movements. Instead, they bet on the mispricing of a share/asset that has happened between two related markets. It is seen that the mispricing of security is far more frequent in high volatility months than in low volatility months.
Thus, Sundaram Mutual Fund as well launched Sundaram Arbitrage Fund (SAF), an open-ended arbitrage scheme investing in arbitrage opportunities. The scheme will follow arbitrage strategy and invest at least 65% of its total assets in equity & equity related instruments as per the mandate under normal and defensive conditions and will hedge its assets.
Hence in terms of risk-return potential, SAF is moderately low and suitable for investors who have a moderately low risk-appetite and are seeking income through investment in fully hedged equity investments (arbitrage opportunities) and fixed income instruments.
Table 1: Details of Sundaram Arbitrage Fund
| Type | An open-ended scheme investing in arbitrage opportunities | Category | Arbitrage fund |
| Investment Objective | To generate income with minimal volatility by investing in equity, arbitrage strategies which fully offset the equity exposure and investments in debt instruments. However, there can be no assurance that the investment objective of the Scheme will be realized. | ||
| Min. Investment | Rs 100 and in multiples of Re 1 thereafter | Face Value | Rs 10 per unit |
| Plans |
|
Options |
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| Entry Load | Nil | Exit Load | For redemption within 15 days from the date of allotment – 0.25%. For redemption on or after 15 days from the date of allotment – Nil. |
| Fund Manager | Mr S Bharath & Mr Rohit Seksaria | Benchmark Index | Nifty 50 Arbitrage Index |
| Issue Opens | 16/01/2020 | Issue Closes: | 30/01/2020 |
(Source: Scheme Information Document)
How will the scheme allocate its assets?
Under normal circumstances, the asset allocation pattern shall be as under:
Table 2a: Asset Allocation under normal circumstances
| Instruments | Indicative allocations (% of Total Assets) | Risk Profile | |
| Minimum | Maximum | ||
| @ Equities and equity Linked instruments | 65% | 100% | High |
| @Derivatives including Index Futures, Stock Futures, Index Options and Stock Options, etc. | 65% | 100% | High |
| Debt securities, money market Instruments & cash and cash equivalents | 0% | 35% | Low to Medium |
@The fund will not have any net long equity and all equity positions will be hedged fully i.e. the equity portion of the Scheme will be hedged 100% at all times.
(Source: Scheme Information Document)
In times where arbitrage opportunities are scarce / not attractive the asset allocation to be as follows:
Table 2b: Asset Allocation under defensive circumstances
| Instruments | Indicative allocations (% of Total Assets) | Risk Profile | |
| Minimum | Maximum | ||
| @ Equities and equity Linked instruments | 0% | 65% | High |
| @ Derivatives including Index Futures, Stock Futures, Index Options and Stock Options, etc. | 0% | 65% | High |
| Debt securities, money market Instruments & cash and cash equivalents | 35% | 100% | Low to Medium |
@The fund will not have any net long equity and all equity positions will be hedged fully i.e. the equity portion of the Scheme will be hedged 100% at all times.
(Source: Scheme Information Document)
What will the Investment Strategy be?
The Sundaram Arbitrage Fund will seek to achieve its objective by investing in equity, arbitrage opportunities that fully offset the equity investments and debt/money market instruments. The investment in equities would be a blend of top-down and bottom-up approach without any market capitalization bias. Arbitrage opportunities would seek to exploit mispricing between cash and derivative market.
The scheme will not have any net long equity and all equity positions will be hedged fully, i.e. the equity portion of the scheme will be hedged 100% at all times. Plus, the scheme will also invest in debt and money market instruments.
The returns generated for the scheme would come from the following: Arbitrage Opportunities – The market provides opportunities to derive returns from the implied cost of carry between the underlying cash market and the derivatives market.
This provides for opportunities to generate returns that are possibly higher than short-term interest rates with minimal active price risk on equities. The implied cost of carry and spreads across the spot and futures markets would potentially lead to profitable arbitrage opportunities.
Debt and Money Market Instruments: The fund may invest up to 35% in normal circumstances of the net assets of the scheme into debt and money market instruments. The investment in debt securities will be guided by credit quality, liquidity, interest rates and their outlook. And the scheme may also invest in the schemes of mutual funds.
The Investment Process may be classified into:
- Research & Analysis
- Approval of Securities
- Portfolio Construction & Selection of Investment
- Monitoring
Diagram: Investment process
(Source: Scheme Information Document)
Who will manage Sundaram Arbitrage Fund?
The Sundaram Arbitrage Fund will be co-managed by Mr S. Bharath and Mr Rohit Seksaria.
Mr S. Bharath a commerce graduate (B. Com), completed his MBA, Financial Risk Management (FRM) and ICWA. He has 6 years of experience in Fund management.
He has been associated with Sundaram Asset Management Company Ltd from April 2018. Prior to that, he has worked as a Fund Manager and Research Analyst.
Currently at the fund house, some of the schemes which Mr S. Bharath manages include Sundaram Smart Nifty 100 Equal Weight Fund, Sundaram Value Fund Series II to Sundaram Value Fund Series X and Sundaram Long Term Tax Advantage Fund Series I to Sundaram Long Term Tax Advantage Fund Series III, Sundaram Infrastructure Advantage Fund and equity portion of Sundaram Equity Savings Fund.
Mr Rohit Seksaria, has a bachelor’s degree in commerce (B. Com), a PGDM and is a CFA. He has a work experience of over 12 years in Fund Management and Equity Research. He is a dedicated fund manager for investments in overseas securities.
Mr Rohit is currently an Assistant Fund Manager of Equity at Sundaram Asset Management Company Ltd. Before joining the fund house, he was a Senior Analyst at Progress Capital Pte Ltd, Singapore and Matchpoint Investment Management Asia Ltd, Hong Kong. Prior to that, at Irevna Research Services Ltd he worked as the Head of Research and as a manager at UTI Mutual Fund.
Currently at the fund house, some of the schemes which Mr Rohit jointly manages include, Sundaram Long term micro cap tax advantage Fund Series III to Sundaram Long term micro cap tax advantage Fund Series VI, Sundaram World Brand Fund Series – II and Sundaram World Brand Fund-III, Sundaram Select micro cap Series VIII, Sundaram Select Micro Cap – Series XII and Sundaram Select Micro Cap – Series XIV to Sundaram Select Micro Cap – Series XVII , Sundaram Services Fund, Sundaram Debt Oriented Hybrid Fund (equity Portion), Sundaram Long term cap tax advantage Fund Series III and Sundaram Long Term Tax Advantage Fund – Series IV Sundaram Emerging Small Cap – Series I to Sundaram Emerging Small Cap – Series VII, Sundaram Long Term Tax Advantage Fund – Series III and Sundaram Long Term Tax Advantage Fund – Series IV.
The outlook for Sundaram Arbitrage Fund.
Sundaram Arbitrage Fund proposes to invest in arbitrage opportunities to generate income with minimal volatility. Since SAF is skewed more towards equities, the fortune of scheme will be closely linked to how astutely the fund managers cites these opportunities.
As mentioned, the scheme proposes to invest in equity and equity related instruments by identifying and exploiting price discrepancies in cash and derivative segments of the market. These investments by nature are volatile as the prices of the underlying securities are affected by various factors such as liquidity, time to settlement date, news flow, spreads between cash and derivatives market at different points of time, trading volumes, etc.
Tapping arbitrage opportunities is a challenging task, owing to the key risks associated with the arbitrage strategy:
* Lack of opportunity available in the market
* The risk of mispricing or improper valuation and the inability of derivatives to correlate perfectly with underlying assets, rates, and indices.
* Execution Risk: The prices which are seen on the screen need not be the same at which execution will take place. This is because arbitrage opportunities are often short-lived.
Another noteworthy point is that the SAF is also expected to have a high portfolio churn, especially in a volatile market. While there is an execution risk when implementing arbitrage strategies across various segments of the market, it may result in missed investment opportunities, or may also result in losses/high transaction costs.
Hence, the performance of the Sundaram Arbitrage Fund depends on the swift effective versatile construction of the portfolio using the arbitrage strategy.
Thus, as an investor, before you invest in any arbitrage fund, you ought to recognise that arbitrage opportunities might not always work out. Since there’s a 10% Long Term Capital Gains Tax (LTCG) on arbitrage funds for gains above Rs 1 lakh in a financial year, arbitrage funds have become unattractive for big-ticket investments.
[Read: How LTCG Tax On Equity Investments Can Derail Your Financial Plan]
So, before investing consider your investment objective, time horizon, and risk appetite.
This article first appeared on PersonalFN here
