Arbitrage funds got a definite leg up in the volatile markets of last year. As a category, these funds returned approximately 7.4 per cent, an improvement on their performance in 2009 and 2010. Diversified equity funds declined by 7.4 per cent on an average in the above period.

Arbitrage funds typically draw mileage from the momentary mispricing between stocks, in the cash and derivatives markets, and are essentially market-neutral. Their return-potential therefore, is a function of the frequency and profit margins of the arbitrage opportunities that present themselves.

The volatile markets of last year, therefore, proved to be a fertile hunting ground for arbitrage funds, helping them make a comeback. Incidentally, the heightened volatility in 2008, too, had presented many such arbitrage opportunities, helping these funds score better than equity funds then.

But their returns, in relation to the risks taken, failed to match up with that of low-risk fund categories, thus taking the sheen off their scorecard.

RISK-RETURN MISMATCH

With equities as an asset class underperforming this year, the returns put up by arbitrage funds compared favourably with the diversified equity funds' category average. But the better performance put in by liquid funds stole the thunder from arbitrage funds. Liquid funds, considered the least risky, managed a higher 8.7 per cent return during the year. For that matter, even other low-risk avenues such as debt funds and fixed deposits managed to deliver better.

DIVERGENT PATTERNS

While the increase in trade volumes in the derivative segment made it difficult for arbitrage opportunities to come their way, arbitrage funds were also hurt by broad-based redemptions. Top funds such as UTI-SPrEAD, HDFC Arbitrage, and IDFC Arbitrage Plan A saw their assets under management drop by 24-71 per cent during the year, driven by redemptions. Kotak Equity Arbitrage, which has the highest assets under management in its category (Rs 125 crore), and SBI Arbitrage Opportunities, the second-highest (Rs 75 crore), however, saw only a 2-8 per cent drop in their AUMs.

Within the category, the returns seem to have been divergent. While UTI-SPrEAD topped the charts with a one-year return of 8.4 per cent, Goldman Sachs Derivate Fund came in last with a 6.3 per cent returns. It merits attention here that UTI-SPrEAD has been the top performer across both three-year and five-year timeframes too.

SUITABILITY

While arbitrage funds are particularly suitable in volatile markets, their returns are always in the green as they lock in on profits while executing trades. That means, while they may or may not manage high gains on their bets, they cannot get in to losses. Arbitrage funds therefore, at best, serve as a portfolio diversifier to hedge against equity market downside. Taxed as equity funds, they also offer a tax advantage over debt funds.

Queries may be e-mailed to >mf@thehindu.co.in, or sent by post to Business Line, 859- 860, Anna Salai, Chennai 600002.

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