I have always entered the stock markets, when scripts were overvalued and exited it,when they were near the rock bottom. My broker used to say that I lost money due to the “volatile markets” . Nowadays, I dread the word “volatility” so much that, I want it to pay for all my misfortunes. Finally I think my prayers have been answered in form of “Arbitrage funds”.

The arbitrage fund takes advantage of the difference in pricing between the cash and the derivative markets. Going long in the cash market and short in the futures market and vice versa. This hedges the risk and ensures that the returns are green in color.

But is that so easy? No it’s not! It important to spot the arbitrage opportunity in the market which is the forte of an efficient Fund Manager. The fund manager thrives on volatility in the market. So did the fund managers lap it up when market provided an opportunity to die for on may 18?

So how did the arbitrage funds perform on the Golden Monday?

The average growth of such funds for 2008-2009 was around 8%p.a. but the average growth for the month of May 09 itself is 5%. Hence, it clearly means that at the 5% growth rate, the average per annum growth will be 60%, This is stupendous, even if one compares growth rate of the best performing stocks in the share market. The arbitrage funds have proved that it performs best, when there is volatility in the market.

The arbitrage funds have proven to be a consistent performer over a period of time. The arbitrage funds gave a return of around 8% even when most other equity funds saw their net asset values (NAVs) falling by over 40 per cent.

From April 2008-09, when the net asset values (NAVs) of mutual funds declined by 30 to 50 per cent and the Sensex also declined by about 60 per cent, during the same period arbitrage funds have given returns of about 8.5 per cent. For arbitrage funds, stock prices are not significant but volumes in futures are of much more importance. In 2008-09, volumes in future trading were about Rs 85,000 core per day and now they have come down to about Rs 15,000 crore per day. For better returns in arbitrage funds, both volatility and volumes are required as they create more investment opportunities.

The most important feature of arbitrage fund is that it generates returns irrespective of whether the markets are in positive or negative. It’s gives returns regardless of the market situation. It’s a win win situation for the investors.

Although, the arbitrage funds are equity linked, the investors should not compare it with normal equity funds. The major difference is that the arbitrage funds are partially exposed to the equity market. They just take the advantage of price difference between the cash and the derivative markets. The arbitrage funds are low risk compare to the equity funds. Such funds render some stability to the portfolio and ensure positive returns in volatile times. It is advisable to allocate a small part of your portfolio to such schemes.

The only downside of this is that the investors are not realizing the potential of the arbitrage funds. The arbitrage fund’s Asset Under Management (AUM) saw a considerable dip during last year, when the investors were vary of any equity linked funds. A part of this can be attributed to the fact that some of the investors are not aware of the real benefits of the arbitrage funds. The other reason can be the investors inability to differentiate between normal equity fund and the arbitrage fund.

The arbitrage funds are a win-win situation for investors. It’s the exact remedy for the volatility in the market . An investor should realize this and make the most of it.

Now you know how to make most of the volatility in the market, get the arbitrage advantage and make volatility pay back to you.

Mutual funds constitute a unique investment gateway where you can invest a small sum and reap the benefits of a well-diversified portfolio selected by professionals, who are not only accountable to their seniors at the mutual fund but also responsible to you as the investor. The mutual fund as a concept is not new, the foundation of the modern mutual fund laid with the establishment of Massachusetts Investors Trust (now MFS Investment Management) in 1924. In India, the mutual fund story started in 1964 with establishing the Unit Trust of India (UTI) by an Act of Parliament. Subsequently, in the years 1987-1993, public sector funds entered in the fray. In 1993, the first mutual fund regulations came into existence, under which all mutual funds, except UTI were to be registered and governed. This paved the way to private sector funds and international players. The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised set of regulations in 1996. The industry is now governed by the SEBI (Mutual Fund) Regulations 1996.

The composition of mutual fund consists of three entities - sponsors, trustees, and Asset Management Company (AMC).  The sponsors initiate the idea to set-up a mutual fund and arrange/organize capital. Trustees secure the necessary approvals from SEBI to float the schemes. The trustees enter into a management agreement with the AMC to manage the money collected through various schemes. The AMC takes investment decisions, maintains proper accounting and information, calculates the NAV, and provides all relevant information.

Mutual funds offer many types of schemes with the objective of offering many options to the investors to match their investment objectives. These schemes can be broadly divided into following generic categories:

• By structure, such as open-ended/interval/close-ended schemes
• By investment objective, such as growth, income, balanced and money market schemes.
• Other schemes, such as tax-saving schemes, index schemes, and sector-specific schemes

Mutual funds offer many unparalleled advantages in investing, such as professional management, portfolio diversification, low costs, liquidity, transparency, and flexibility.

Criteria of mutual fund selection

There is nothing that can completely ensure that the investor will earn maximum returns but the following fund parameters will help to reduce risk and enhance returns:

• Size of Asset Under Management (AUM): A large-sized AUM not only helps to reduce cost but also puts the fund in a position to absorb risk and liquidity crises in a better way.
• Past Performance: Past performance of a mutual fund does not guarantee anything for the future but it definitely indicates the ability of its fund managers.
• Lower Investment Management Expenses: It is generally favorable for the investor to choose schemes with lower Investment management expenses.
• Low Portfolio Turnover: High portfolio turnover unnecessarily increases transaction cost, hence look for funds with low portfolio turnover to take the cost advantage.
• Evaluation of Indicative Portfolio: An investor should properly evaluate a fund’s indicative portfolio and try to avoid schemes with exposure in underperforming sectors.

Matching Investment Objective with Schemes

Every investor has one goal - to maximize returns subject to his/her risk appetite. Mutual funds give a lot of options to enable one reach or get close to one’s desired goal.

• Corporates/individuals can put idle money in liquid funds rather than savings accounts and earn much better returns. Money can be withdrawn from liquid mutual funds by giving just one day’s notice.
• If an investor plans to earn reasonable returns for a period in the range of three months to more than a year, fixed maturity plans (FMP) are a good option. In case of FMPs of more than one year’s tenure, an investor can also take the advantage of long term capital gains.
• If an investor wants to invest on a recurring basis, a systematic investment plan (SIP) is a good option. Its long duration helps to reduce the impact of bull and bear phases.
• Investors with very high risk appetites and good understanding of the market can always look for equity or equity-oriented mutual funds. If the investor feels that a particular sector will do well, he/she can choose sector-specific schemes. Mutual funds also have the expertise to hedge investments to ensure lesser downside risk.
• If the investor wants to enjoy fixed income with a mix of equity returns, he/she can go for balanced/debt-oriented/equity-oriented mutual fund schemes.
• An investor can choose the dividend/growth option as per his/her requirement of funds. Dividend is tax-free income for the investor.

Final Thoughts

But the bigger fact remains that it is your money, you should not rely on anybody with closed eyes. In the worst scenario, even considerably safe investments like FMPs can give negative returns. You should always be in touch with the market or at least watch the Sensex on a regular basis. An informed investor can always use the option of switching from one particular scheme to a liquid fund and vice versa at appropriate times. However, by investing through mutual funds you can take advantage of expert selection of securities, daily monitoring, risk reduction, lower cost etc. and improve your returns.

Prabhat Varma works as General Manager (Finance), Sahara India Financial Corporation, Mumbai.