The equity markets in India are at an all-time high and so are stock valuations. The benchmark BSE Sensex breached the 53,000 mark for the first time on Tuesday. The index is currently trading at around 32 times its earnings per share in trailing 12 months, nearly 20 per cent higher than its pre-pandemic valuation.
Most analysts on Dalal Street however remain bullish and expect the markets to go even higher though the downside risks for investors are increasing as stocks become even more expensive. The risks are especially high given the steady rise in inflation and India’s growing import bill due to higher crude oil prices.
A good way for investors to hedge their investment bets in the equity markets is to invest in Arbitrage Funds. These funds can also be used to park excess funds that you may have generated by booking profits in your equity portfolio.
Though technically they are equity funds, arbitrage funds behave more like debt or liquid funds. These funds are also marketed as equity savings or saver funds.
The price gap between the cash market and the future market called spread is the fund profit or the returns. For example, on Wednesday, Infosys closed at Rs 1503 per share in the cash market and Rs 1512 per share in the futures market for expiry date on July 29.
The price gap expands or contracts depending on the new flows and the market economic condition. But in a normal market, spreads or potential returns reflect the near term interest rates or the bond yields. So when interest rate or bond yields decline, returns from arbitrage funds decline.
Investment in debt cushions the volatility in returns from the equity markets. The structure of the portfolio means that the arbitrage funds carry much less risk than simple equity funds but offer the potential to beat the returns offered by debt funds due to the price arbitrage opportunity in the equity market.
Excessive market volatility can result in an abnormal rise in price spreads between the cash and the future markets that juice up the returns of arbitrage funds.
For example, in the last one year, arbitrage funds have delivered 12.2 percent returns on average which is nearly twice the yields on fixed income products such as bank FDs according to data from ICRA Analytics – Mutual Fund India.
This makes them a better option than plain vanilla money market funds, liquid funds or ultra-short -term bond funds.
This is because the near term returns from arbitrage funds could be even negative due to market volatility and long-term returns are closer to the returns offered by bond funds. This puts arbitrage funds at disadvantage due to their much higher expense ratio compared to bond funds.
For example, the top ranking arbitrage funds - HDFC Equity Savings Fund has expense ratio of 2.2 per cent against 1.5 percent charged by ICICI Prudential All Seasons Bond Fund - the top ranking bond fund.
This makes arbitrage funds a superior alternative to bank deposits or money market funds to park excessive funds especially if you won’t require those funds for at least six months.
However, one must be careful while selecting the right arbitrage fund to invest-in. There is a great variability in the returns offered by the various funds in the segment. For example, less than half of funds in the segment (14 out of 30) have given double digit returns in the last one-year.
But we have made the task easier for you. We have selected the top five arbitrage funds in the market right now based on their returns in the short-term and the long-term. In our analysis, we have only considered funds with AUM of Rs 100 crore or more. All data has been sourced from ICRA Analytics.
1. HDFC Equity Savings Fund tops the charts with one-year returns of 27.73 percent and 5-year annualised returns of 10.46 percent which are way higher than what one can generate from any fixed income instrument.
2. SBI Equity Savings Fund comes second with one-year returns of 26.67 percent and 5-year returns of 8.84 percent. At 1.42 percent it has one of the lowest expense ratios in the category that makes it even better.
3. Axis Equity Saver Fund is ranked number three with one-year returns of 22.93 percent and 5-year returns of 9.46 percent per annum. However, it is an expensive fund with an expense ratio of 2.5 percent.
4. Aditya Birla Sun Life Equity Savings Fund ranks fourth with one-year returns of 24.8 percent and 5-year annualised returns of 8.87 percent. Its expense ratio is 2.44 percent, at par with category average.
5. Edelweiss Equity Savings Fund is ranked fifth with one-year returns of 18.67 percent and 5-year returns of 9.3 percent. The fund also scores on expense ratio which at 2.04 percent is on the lower side among its peers.
(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).