Arbitrage funds aim to generate income through opportunities from price differences between the cash and derivatives markets, and also by deploying some of the surplus cash in fixed income instruments.

The total average assets under management (AAUM) of 15 arbitrage funds in India dropped to Rs 955 crore as of December 31, 2010, from Rs 4,105 crore as of April 31, 2010, according to data provided by Value Research. The AAUM data of arbitrage funds is available only till December 31.

Arbitrage schemes that saw the highest drop in AAUM during April-December 2010 were Birla Sun Life Enhanced Arbitrage (down 97 per cent), HDFC Arbitrage Retail (down 85 per cent), JM Arbitrage Advantage (down 82 per cent) and SBI Arbitrage Opportunities (down 78 per cent).

“The key reason (behind the sharp drop in assets of arbitrage funds) is the lack of arbitrage opportunities, given the increased volume in derivatives, especially options, and also higher returns by liquid funds in the last few months,” said Tarun Bhatia, director-capital markets, Crisil Research. “Arbitrage funds are typically sold by distributors as an alternative to liquid funds. With lack of arbitrage opportunities, the returns on such funds started diminishing. Further arbitrage funds involve higher transaction costs, bringing down returns post taxes,” he added.

Arbitrage funds have given returns of five-seven per cent per annum in the past year. With the rise in interest rates, FMPs of mutual fund houses are now yielding close to eight per cent, after tax. FMPs seek to generate income by investing in a portfolio of debt and money market instruments maturing on or before the maturity of its own scheme.

“Arbitrage funds tend to lose their attractiveness when yields on debt instruments get attractive. Currently, yields on FMPs and debt funds are high, resulting in better post-tax returns in debt schemes,” said Srikant Subramanian, research analyst at Morningstar India.

To tame inflation, the Reserve Bank of India (RBI) has increased its key policy rates — repo and reverse repo — eight times since March 2010. This has resulted in increase in yields for both government and private sector debt instruments, in which FMPs invest.

source: Business Standard

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