Arbitrage funds for near-alpha return?

An active fund’s total return comes from two components- returns in line with benchmark index (beta returns) and returns more than the benchmark (alpha returns). You pay a higher fee for an active fund compared with a passive one for the expected alpha returns. But a huge proportion of an active fund’s return is driven by market returns. This means an investor pays higher fee for market returns too.

Large U.S.-based institutional investors argued against such practice; for market returns can be earned by investing in cheap passive products. That paved the way for alpha-beta separation in institutional investing. Think of this as earning market returns from a pure passive product and alpha returns from specialist alpha managers.

Retail investors do not have access to such process. But they can invest in exchange-traded funds or index funds to generate beta returns and invest in arbitrage funds to get near-pure-alpha returns. This week, we discuss why arbitrage funds offer such exposure.

Synthetic process

A portfolio can be created to carry only market risk via the process of diversification. Creating a near-pure-alpha portfolio needs multiple steps. The first is to create typical portfolio like an active fund. This will contain both market, company-specific and sector-specific risk. The next step would be to remove market risk from portfolio. That will leave company-specific and sector-specific risk in the portfolio to earn alpha returns. This process is achieved using index futures on the portfolio’s benchmark index. Suffice it to know the process cannot clinically remove all market risk.

Residual beta

Some market risk that stays in the portfolio is referred to as the residual beta. Hence, the portfolio is said to achieve near-pure-alpha returns. Arbitrage funds apply a simple process to achieve such returns. Such funds identify stocks with overpriced futures contracts. Then, they take long position in such stocks and short position in the futures contracts to capture the price difference. The long stock and short futures position ensures the portfolio has near-zero market risk and near-pure alpha returns.

Conclusion

Markets do not always offer arbitrage opportunities. Market participants try to grab opportunities quickly when such opportunities are available.

Therefore, there could be times when arbitrage funds may not find investment opportunities. So, such funds also take exposure to money market instruments to generate returns, keeping the risk low. You must be mindful of these factors if you invest in arbitrage funds.

(The author offers training programs for individuals to manage their personal investments)