Your Money: An arbitrage-plus strategy

Conservative investors should wait to see how the strategy works before they invest

So far, fund houses have tried to enhance the returns from a pure arbitrage fund by adding an equity component to the portfolio. Now, BNP Paribas Mutual Fund has launched the BNP Paribas Enhanced Arbitrage Fund where the fund manager will attempt to augment return by pursuing a simultaneous long-short strategy in the equity portion of the portfolio.

A normal arbitrage fund tries to earn returns by locking into the spread between the cash and futures segments of stocks. This fund’s portfolio will have three components. About 40-45 per cent of the portfolio will follow the normal arbitrage strategy. Another 30-odd per cent will be invested in a liquid fund. The rest, 20-25 per cent – the enhanced arbitrage component – will be the differentiator. Here, the fund will follow a long-short strategy. The fund manager will create a long equity portfolio (a large-cap oriented, fundamentally-based portfolio of 35-40 stocks), and he will simultaneously go short on Nifty futures for an equal value. “The fund’s performance will not depend on market direction. Whether the market moves up or down will not matter. As long as we outperform the Nifty, we will create alpha in this 25 per cent of the portfolio,” says Karthikraj Lakshmanan, senior fund manager (equities), BNP Paribas Mutual Fund.

The fund will carry a little higher risk than an arbitrage fund and a liquid fund, but will also have the potential to offer slightly higher returns than them. It will, however, have a lower risk-return profile than monthly income plans (MIPs). MIPs also invest about 20 per cent of the portfolio in equities (and the balance of debt), but they have a long-only equity portfolio. The equity market must move up for them to do well.

Since the equity-plus arbitrage component of the fund will exceed 65 per cent of the portfolio, it will enjoy tax treatment at par with equity funds. The fund is targeted at investors who are looking for higher returns and can take a little higher risk, than in a pure arbitrage fund. The ideal investment horizon for it is 12-18 months.

With interest rates within the economy coming down, returns from arbitrage funds have also contracted. Over the past year, they have generated an average return of 6.30 per cent. This fund should ideally deliver slightly higher returns than arbitrage funds. On a post-tax basis, arbitrage funds, including enhanced strategies, may still make sense compared to many products with a similar risk profile due to the zero tax on capital gains after one year, especially for investors in higher tax brackets.

According to experts, the fund doesn’t have a pure long-only strategy in the equity portion as other enhanced arbitrage funds do. So, it will be less volatile than those funds. However, it does have its share of risk. “In a falling market, the stocks in the portfolio should fall less than the benchmark, and in a rising market, they should rise more than the benchmark. Only then will the equity portion add value,” says Kaustubh Belapurkar, director-manager (research) at Morningstar Investment Advisor India.

The fund’s strategy is novel. However, investors should wait until the fund house has demonstrated its proficiency at executing this strategy. Once a soundtrack record is available, low-risk investors may bet on the fund.