Arbitrage and Aggressive Hybrid Funds: How Their Risk and Return Profiles Differ

When you hear the word “hybrid”, what comes to mind is a mix of equity and debt, right? But not all hybrid funds are made equal. Some funds are engineered to completely hedge out market risk, whereas some seek to take on market risk to make money.

To understand this contrast, look at the two extremes of the hybrid spectrum: arbitrage mutual funds and the aggressive hybrid fund. They both use a mix of assets, but their goals, mechanics, and risk profiles are entirely different.

Let’s understand the difference between the two by studying the two ends of the spectrum – the arbitrage mutual funds and the aggressive hybrid fund. Both are types of hybrid mutual funds but the former seeks to make money out of market inefficiencies while the latter seeks to balance out market risk.

The Mechanics of Arbitrage: Hedging the Market Away

Arbitrage mutual funds are the illusionists of the mutual fund universe. They create the magic of generating returns without taking on any market risk. Arbitrage funds make money out of the price inefficiencies of the same stock in the cash and futures market.

Let’s say a stock is trading at ₹1,000 on the cash or spot market and ₹1,020 on the futures market. That’s a ₹20 spread between the two. The arbitrage fund would buy the stock on the cash market and sell it on the futures market. Once the contract expires, the futures stock is bought back to close the trade and the arbitrage fund makes a cool ₹20 per share. Since the futures contract is sold at the same time the cash market stock is bought, it does not matter if the stock price falls or rises – it makes no difference to the trade.

Of course, there can be execution risk which means that the spread gets eaten away due to low liquidity and the trade may not yield the expected return. These funds are typically low risk and work best in a volatile market scenario where the price spread tends to be larger. These funds typically act like a low-volatility debt fund when the market is not volatile.

The Aggressive Hybrid Blueprint: Balancing Growth and Stability

Now, let’s talk about the aggressive hybrid fund. These are funds like the SBI Equity Hybrid Fund and the Mirae Asset Aggressive Hybrid Fund that take on market risk. Aggressive hybrid funds invest at least 65% in an equity portfolio while the balance is invested in debt instruments.

Aggressive hybrid funds are designed to generate capital appreciation over the long term. During positive market conditions, aggressive hybrid funds participate in the upside of the equity markets and during down markets the debt component protects the portfolio from significant losses.

Comparing the Risk Engines

While arbitrage mutual funds tend to have lower risk due to the market neutral nature of the strategy, aggressive hybrid funds have a moderate to high risk profile due to the 65%+ equity exposure. The downside risk of aggressive hybrid funds is similar to a large-cap fund but with lower downside risk due to the debt component. An aggressive hybrid fund is typically recommended for investors with a 5+ year investment horizon. As for arbitrage funds, they are suitable for an investor looking to park their money for a few months without having to take on much risk.

The Cost Factor: Expense Ratios

Arbitrage funds have higher expense ratios due to the frequent trading involved to book spreads. Make sure that the expense ratio is not cutting into your returns much. In the case of aggressive hybrid funds, the expense ratios vary widely. The Mirae Asset Aggressive Hybrid Fund has an expense ratio of 0.39% while the UTI Aggressive Hybrid Fund has an expense ratio of 1.19%. The difference in expense ratios can impact your returns greatly when you consider a 10-year investment horizon.

The Tax Advantage

Both these categories of funds have a tax advantage over conventional mutual funds. That’s because the tax treatment of arbitrage funds is similar to equity funds. Any long term (more than one year) capital gains are taxed at 12.5% of the amount exceeding ₹1.25 lakh. The same applies to arbitrage mutual funds.