What are arbitrage funds? When are these funds appropriate for you?

In the last couple of years, one category among the mutual funds has gained popularity – the arbitrage funds. It is important to understand what these funds are, how they work and what purpose these serve. One must also understand the risks involved in these funds. Click here to read my article published in Mid-day Gujarati edition.

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The English translation of the article is as under:

What are arbitrage funds? When are these funds appropriate for you?

In the last couple of years, one category among the mutual funds has gained popularity – the arbitrage funds. It is important to understand what these funds are, how they work and what purpose these serve. One must also understand the risks involved in these funds.

We covered this category in our column on February 6, 2017 with proper example. However, we feel that there are a few misconceptions around this category that need to be clarified, especially looking at the amount of money getting parked in these funds. Many consider this as safe as liquid funds, with the benefit of lower (or zero) taxation.

Arbitrage is a strategy to generate returns due to the price difference between two different markets for the same (or similar) securities. This often happens between the cash segment and futures segment of the stock markets, on account of what is technically known as the “cost of carry”. This “cost of carry” is akin to interest charged for short term borrowing.

However, since the money is invested in stocks (at least 65% of the scheme’s corpus), the fund is treated as “equity oriented fund” according to the Income Tax Act. This means the dividend is tax exempt in the hands of the investor, as well as exempt from the dividend distribution tax. Capital gains are tax-exempt, if the holding period is more than one year. Even when the capital gains are booked for a holding period of less than a year, the same is taxed at a lower rate of 15% and not clubbed with the income.

This tax arbitrage is drawing a lot of money towards these funds. However, it is important to understand the investment before getting on to the discussion of taxation. The investment theory must precede considerations of tax and the investment theory would help one analyse the risk-reward trade-off.

First of all, let us make one point clear: as per the classification for purposes of income taxes, arbitrage funds may be classified as equity-oriented funds, but in terms of investment theory, these are alternatives of liquid funds. Hence, please do not expect returns in line with equity funds. These funds can generate investment returns very similar to those generated by liquid funds.

At the same time, while liquid funds invest in money markets and debt markets; arbitrage funds exploit arbitrage opportunities between two different segments within the equity markets.

Pure arbitrage is considered to be an almost zero risk strategy, since the prices converge on expiry of the futures contract. However, there is a possibility that the spreads widen before the contract expires. In such a case, there could be negative returns, temporarily. One must be aware of this.

Such short term negative returns may coincide with your parking horizon and thus, you may end up with very low or even negative returns, if you have parked money for very short periods of time. This only means that one should not treat arbitrage funds as a total replacement of liquid funds, but use these only when the time horizon is slightly long, say at least one month.

In spite of the risk highlighted, the arbitrage fund could be a good place to park your fund and enjoy the reduced taxation.

-       Amit Trivedi

Liquid mutual funds offer the facility to get instant access to your money

Many do not know this facility offered by certain mutual funds - instant access to your money. Though, it is is for a limited amount currently, it still remains to be a great facility. Click here to read further.
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The English translation of the article is as under:

Many people keep large sums of money in current and savings accounts. They do it for a simple reason: what if the money is needed urgently?

Well, how urgent could be the need? And how much money may be required in such an emergency? It is in just a handful of exceptional cases that one has bothered to consider these two questions.

Most others operate out of fear. The fear is fully expressed in the earlier question about the urgent need. They support this argument further by stating that the emergency comes unannounced. It gives no time for any preparation. The argument is correct that there is no prior notice before an emergency. However, consider any situation – the emergency may come unannounced, but is there some time before money may be required? Even in case of hospitalization, how much money is required upfront? Will the hospital deny admission?

This is where one may consider some unconventional options to put the money to a better use. These options are the innovations in the financial markets that can be used to your advantage.

One such innovation is the liquid mutual funds that can be used for parking money for very short periods of time. One may also consider parking money for as short a period as three to four days. There is no limit on the maximum period for which such funds can be used. The beauty of these products is that there is no maturity period and the investor also need not specify for what period the investment is being made.

These funds have the potential to deliver more than what one gets from savings bank accounts or bank deposits of less than a year’s maturity.

Through a recent development, the regulator has allowed instant redemption facility from these liquid funds upto a maximum of Rs. 50,000 per account or 50% of the balance in the folio, whichever is lower. On redemption, the bank account would be credited within half an hour. This is a fantastic facility in case of emergency.

So go ahead and utilize this facility from the liquid funds.

- Amit Trivedi
The writer is the author of a book "Riding The Roller Coaster - Lessons from financial market cycles we repeatedly forget"

How do fund managers manage debt funds

Debt funds, also known as income funds or fixed income funds invest in a mix of government securities, certificates of deposits of banks, corporate debentures, and some other debt and money market securities. These investments are safer than equity securities in that these do not exhibit the price fluctuations as much as stock markets.

While we have talked about various categories of debt funds, some features of these as well as the risks involved. Today, we will discuss how these funds are managed by the fund managers.

Click here to read further ...

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The English translation of the article is as under:

How do fund managers manage debt funds?

Debt funds, also known as income funds or fixed income funds invest in a mix of government securities, certificates of deposits of banks, corporate debentures, and some other debt and money market securities. These investments are safer than equity securities in that these do not exhibit the price fluctuations as much as stock markets.

While we have talked about various categories of debt funds, some features of these as well as the risks involved. Today, we will discuss how these funds are managed by the fund managers.

The function of fund management team is to generate higher returns for the risk taken or to reduce risk for a given level of risk. In other words, they have to reward the investors for the risks taken. The reward should be higher than what an investor would be able to achieve by oneself.

For that purpose, the fund managers need to manage the risks. Or in other words, they need to take calculated risks. In debt funds, there are three major risks that the fund managers manage in order to generate desired fund performance in line with the scheme objective.

These three risks are:

1.     Credit risk:

When you lend money to someone, there is a contract that the principal amount as well as the interest on it would be returned at a pre-agreed time. However, in certain cases, the borrower is not able to honour this commitment. The possibility of such an event is known as credit risk. In other words, the risk can be mentioned as: “what if the principal or interest payments are not received in time or not received at all?”

The companies where such a risk is high, is expected to pay higher interest, else nobody would lend money to them.

The fund managers understand this risk through a careful study of the financial statements and business of the company, as well as an analysis of overall economic situation. With this analysis, they try to find out securities where the future returns could be higher for the suggested risk.

2.     Interest rate risk:

When interest rates in the economy fall, the existing debentures become more attractive, as they carry higher interest rates. Due to this, investors queue up to buy these debentures from the secondary market, which pushes their market prices up. Thus, as interest rates in the economy went down, the prices of existing debentures went up. The opposite of this is also true.

This sensitivity of debentures to changes in interest rates is called “interest rate risk”. Securities with short maturity period are less sensitive as compared to those with longer maturities.

Fund managers may take a view on the possible change in interest rates in the economy and shift the portfolio accordingly. When the rates are expected to rise, the fund managers sell securities with long maturity and buy those with short maturity. When the rates are expected to fall, they do exactly reverse. In this way, they try to reduce the negative impact of rising rates and maximize the impact of falling rates.

3.     Liquidity risk:

When any investor wants to sell a security, there should be a buyer in the secondary market. In the absence of a buyer, there is no liquidity, or one would be required to sell the same security at a discount. At the same time, if a security is known to be illiquid or less liquid, the interest rate is normally high to compensate for this lack of liquidity.

Most mutual fund managers buy illiquid securities only (1) if the scheme’s objective allows it, or (2) the expected redemptions are less than the liquid component of the portfolio. By maintaining proper balance between liquid and illiquid securities, the fund managers are able to get higher interest income as well as provide redemptions without hassles to investors.

So, go ahead and enjoy the fruits of professional management by investing through debt funds.

- Amit Trivedi

Transcript of today's chat on www.moneycontrol.com

Equity investments simplified

Equity investments simplified - chat transcript

Readers questions answered today. See the transcript below:

http://www.moneycontrol.com/news/mgmtinterviews/chats/detail_new.php?chatid=2796

How do you know which scheme you have invested in?

"How do you know where the mutual fund scheme invests our money?"

To understand the answer to this basic question, click here to read my article in today's Mid-day Gujarati, Mumbai edition.

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The English translation is as under:

Recently, after an investment seminar, someone approached me and asked a very basic question: “How do I know if a mutual fund scheme is an equity fund, a balanced fund, a debt fund or a liquid fund?” Well, for someone who has spent more than a decade and a half in mutual fund industry, this was unthinkable. However, the question only reflects that there is still a lot of work required to spread the awareness about a good investment vehicle.

Well, let us come back to the question that the person asked. How does one know what type of a fund it is?

A mutual fund is a portfolio of investments. All of us have a portfolio built by ourselves. We invest some money in bank deposits, some in company deposits, we buy some debentures, we buy some small savings schemes, and we also buy some shares or even a real estate property. We refer to a combination of all these investments together as an investment portfolio.

Similarly, a mutual fund scheme is another portfolio with a few differences. For one, the portfolio referred earlier is self-managed by the investor; whereas the mutual fund portfolio is managed by a professional fund management team. Second difference is huge. While constructing our self-managed portfolios, we normally do not start with some guidelines regarding how we would manage the same. In case of a mutual fund, the scheme’s investment objective, investment style and the investment universe have to be clearly defined in a legal document called the offer document.

It is this offer document that one must refer to in order to understand the details of the scheme. Let us introduce this particular document. An offer document is like a janam-kundli. It is the legal document that binds the fund management company and the fund management team. The fund management team has to manage the scheme in accordance with this document. This is why details like the scheme’s objective, investment style and details of where the money can be invested – are all part of this document. Apart from this basic scheme related details, this document also gives details of the fund management company as well as its promoters, which includes their financial details. This helps one assess the financial and technical strengths of those who manage your money. One can also access information (including the past track record) regarding other schemes managed by the same fund management team. The service and operational details are also a must.

Since the single document was becoming too bulky with too much information, SEBI made an investor friendly change – breaking the document in two parts, viz., Scheme Information and Statement of Additional Information. The former carries details regarding the scheme one is considering, whereas the latter details information regarding the fund management company and other general details.

An investor is required to have read the offer document before investing in the scheme. Please follow this advice as it is always in your benefit to “look before you leap”.

Happy investing

- Amit Trivedi

Get answers to your questions on mutual funds

Do you have questions regarding mutual funds? Get answers during the live chat on www.moneycontrol.com on 7th November, 2016 at 4:00 PM to 4:30 PM

Why mutual funds do not guarantee returns? And why is it good?

Though guarantee is a sought after factor for many investors, it still makes sense not to go for it.

Read more at: http://www.moneycontrol.com/news/mf-experts/why-mutual-funds-do-not-guarantee-returns-andis-it-good_7493481.html?utm_source=ref_article

Equity investments simplified - a chat session on www.moneycontrol.com

I will handle questions on live chat scheduled on 19th September @ 4:00 PM on www.moneycontrol.com

You enjoy your holidays and your money works for you, is it possible?

You enjoy your holidays and your money works for you, is it possible? Read my article on the subject in Mid-day Gujarati edition today. ________________________________________________________________________________ English translation is as under: How does it sound when your money works for you even when you are enjoying your holidays? August is the month of festivals and long weekends. Many of us go for mini-vacations – either on some excursions or to meet our families. During such periods, often the money lies idle in the bank accounts. There are no options where the money can be parked to earn some returns. Bank fixed deposits are available for a minimum period of 15 days if the amount is small. That means, the money remains idle in savings or current accounts. With most banks, the current accounts do not earn a single rupee and the interest on savings accounts is a low 4% p.a. In such cases, mutual funds offer an incredible opportunity in form of liquid funds. It is possible to invest amounts as small as Rs. 10,000 and even for weekends. Many large companies use this facility offered by mutual funds to park money for weekends. The liquid funds are open-ended mutual funds and hence the transaction can be done on any business day. Let us say, there is a holiday on a particular Monday, making it a long 3-day weekend – Saturday, Sunday and Monday. If you have surplus money in your bank account on Friday before these holidays, you can invest the same in a liquid fund and simultaneously file for redemption such that you get the money in your bank back on Monday. In case you do not need the money on Monday, you may continue to stay invested. Mutual funds offer a great flexibility in terms of not declaring the investment period in advance. You may invest your money in a liquid fund without mentioning the date of redemption in advance. You may stay invested till the time you do not need the money. As per the website of Value Research, a leading portal for mutual fund information, the liquid funds have delivered the following returns in the past: Table 1: Period Returns (p.a.) Last week 6.76% Last month 7.08% Last 3 months 7.36% Last year 7.83% (Disclaimer: Past performance may or may not be sustained in future) As you can see, the rates of return are around 7% p.a. However, you may also observe that the returns for the shorter periods are lower than the longer periods. This is not like a bank fixed deposits where they offer lower interest rates for shorter periods and higher for longer periods. This has happened in case of liquid funds since in the last some time, the interest rates have come down. Liquid fund is a product that responds to the changes in interest rates in the market very fast. If the interest rates in the economy start going down, the liquid fund returns would get adjusted and if the rates start going up, the liquid fund returns would improve. Let us do some Math with the above numbers. If you have a surplus of Rs. 5 lacs to be invested for a long weekend (3 days), how much do you earn? Table 2: Assumed rate of return Money earned 6.76% Rs. 277.81 7.08% Rs. 290.96 7.36% Rs. 302.47 7.83% Rs. 321.78 (The rates of return are taken from table 1) If you do not need money, as we mentioned earlier and you keep the money in a liquid fund for 10 days, the earnings would be as under: Table 3: Assumed rate of return Money earned 6.76% Rs. 926.03 7.08% Rs. 969.86 7.36% Rs. 1,008.22 7.83% Rs. 1,072.60 (The rates of return are taken from table 1) If in a year, you get four to five such opportunities, we are now talking about serious money. Liquid funds also offer facilities to transact through SMS, increasing the convenience. In fact, just before writing this article, I invested some money in a liquid fund just by sending an SMS. The redemption from the fund account also happens through an SMS. All you need to do is to get a one time mandate registered. So, what are you waiting for? Enjoy your holidays and let your money work for you. The earning would take care of part of the expenses. -        Amit Trivedi The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

Transcript of chat on Master Your Money segment on 28th July 2016

Click on the link below to read the transcript of my chat today on www.moneycontrol.com:

Build wealth with mutual funds

Master your money - live chat

Live chat on www.moneycontrol.com at 4:00 to 4:30 PM on 28th July, 2016

Questions regarding mutual funds - answered during the chat session today on www.moneycontrol.com

Click on the link below to read the transcript of my chat today on Moneycontrol.

http://www.moneycontrol.com/news/mgmtinterviews/chats/detail_new.php?chatid=2667