Mutual funds: Arbitrage funds find more takers amid volatility

Investors show interest in arbitrage/ dynamic asset allocation funds as returns from liquid funds are falling because of very low yields

At a time when retail investors continue to exit equity-oriented mutual funds to book profits for the seventh consecutive month— net withdrawals were at Rs 9,253 crore in January—some investors are putting money in arbitrage funds. In January, arbitrage funds saw net inflows of Rs 5,235 crore.

In fact, after recording net outflows for six straight months, January saw hybrid schemes attracting net inflows of Rs 2,142 crore in January because of arbitrage and the dynamic asset allocation funds. While arbitrage funds recorded net outflows in November and December, dynamic asset allocation funds have seen net outflows for the previous 10 months.

Analysts say investors are showing interest in these funds as returns from liquid funds are falling because of very low yields. In January, liquid funds reported net outflows of Rs 45,316 crore. They also say the volatility in the stock markets helped arbitrage funds deliver better returns as investors looked for better yields and these funds are a better option for risk-averse investors to invest when there is persistent fluctuation in the market.

Arbitrage funds
In mutual funds, arbitrage funds leverage the price differential between equity shares in the cash market and in the stock futures market. These funds generate returns by harnessing the price differential between the two as they buy in the cash market and sell in the futures market. As the price of a stock in the derivatives market quotes at a premium to its price in the cash market, it gives an arbitrage opportunity which such funds attempt to encash by buying a stock in the cash market and selling it in the futures market. That way, the fund earns the differential premium between the two prices and in volatile market conditions, the returns on arbitrage funds are high.
In arbitrage funds, fund managers are able to handle stock market volatility efficiently over a medium term horizon.

Moreover, fund managers allocate some money to fixed-income instruments to ensure that fund returns are in line with the expectations when there are not adequate arbitrage opportunities. Arbitrage funds invest about 65% of the portfolio in equities and are treated as equity funds for tax purposes. The balance is invested in the money market or debt instruments. So, these have a tax advantage over debt funds. Analysts say investors must look at an investment period of at least three years before investing in arbitrage funds as these funds can be more volatile than liquid funds in the short term.

Dynamic asset allocation funds
In January, dynamic asset allocation funds report net inflows of Rs 658 crore. Investors prefered to invest lump sum in dynamic asset allocation funds as these hybrid funds invest in a mix of equity and debt that time the markets based on valuation-based strategies. In these funds, the fund manager increases the exposure to equities when the investment metrics become favourable and brings it down when the metrics become unfavourable. Depending on the market conditions, asset management companies fix the equity exposure which can improve the risk-adjusted return for long investors.

Analysts say dynamic asset allocation funds provide downside risk protection more than the upside capture of returns. When the market valuations are high, fund managers bring down the equity exposure and when the valuations are low, they increase the equity exposure.

Analysts say investing in dynamic asset allocation funds can help investors take a balanced decision. So, retail investors who would not want to risk by investing and managing on their own and want to rely on the expertise and skills of fund managers in deciding the allocation in equities and debt should invest in these funds.

Hedging the bets
Investors show interest in arbitrage/ dynamic asset allocation funds as returns from liquid funds are falling because of very low yields
In arbitrage funds, fund managers are able to handle stock market volatility well over a medium term horizon
Dynamic asset allocation funds provide downside risk protection more than the upside capture of returns
Arbitrage funds have a tax advantage over debt funds