NFO: BNP Paribas Enhanced Arbitrage Fund

Innovative new product idea adds a touch of pure alpha

Karthikraaj Lakshmanan, Senior Fund Manager, BNP Paribas MF

15th December 2016

In a nutshell

Arbitrage funds are tax efficient, but returns are gradually tapering down in line with market yields. BNP Paribas' new fund adds a touch of pure alpha into an arbitrage fund, to provide that much needed return kicker, while preserving the tax efficiency. A quarter of the portfolio will be allocated towards long/short (market neutral) strategies, in an effort to extract pure alpha while eliminating the beta. This pure alpha spices up portfolio returns without taking too much risk as the market risk gets managed out. The key is to pick the right stocks that can deliver strong alpha - a trait that the BNP Paribas equity team has demonstrated strongly in recent years. Read on as Karthikraaj takes us through this innovative new product idea that spices up the arbitrage funds category.

WF: Can you please explain how the concept of long/short works and why it is considered an "alpha without beta" or "pure alpha" strategy?

Karthikraaj: As the fund is market neutral and aims to outperform the benchmark which is Nifty in order to generate higher returns or alpha. Irrespective of market direction as long as the enhanced arbitrage portion of the fund outperforms Nifty it would add to overall returns of the fund.

WF: What will be the typical tenure of long positions you will take in your preferred stocks against which you propose to short the Nifty as a market neutral strategy? Will these be tactical moves or longer term buys?

Karthikraaj: The equity portfolio will be based on our investment philosophy (BMV). The focus will be identifying long term ideas that can deliver superior returns. The fund will be nimble than the other equity funds.

WF: What will be the leverage levels for your long/short positions? Will a 25% exposure of corpus to long/shorts mean upto 100% gross exposure to this strategy? If you deliver say a 4% alpha in this strategy, would it therefore mean a return of 16% from this component of the fund, due to leverage?

Karthikraaj: There is no leverage in this portfolio. Out of the total AuM only 20-25% of the fund will be invested in long equity portfolio and equal amount will be hedged by shorting Nifty futures. The short positions in Nifty futures earn a carry, which is quite close to money market yields. The alpha that is generated through these long-short positions then adds the incremental return on this component, which helps this part of the portfolio deliver healthy returns and consequently boost overall portfolio returns.

WF: How many individual positions do you normally expect to hold in your long/short strategies? Will there be an attempt at sectoral diversification as a risk mitigation strategy or will it be purely bottom up, go anywhere?

Karthikraaj: As the underlying benchmark is Nifty 50, the portfolio will have a large cap bias with exposure to about 35-40 stocks. We shall be factoring in all risk mitigation factors like sectoral diversification, single stock exposure etc. The fund will use bottom up strategy to identify stocks for this fund using our Business Management and Valuation framework.

WF: When distributors consider this product for their investors, what would be a typical enhancement in returns over a normal arbitrage fund that they should expect?

Karthikraaj: The alpha (outperformance over Nifty) created in the long short portion (which will be 20-25% of fund) will be the key enhancement over normal arbitrage fund.

WF: 1 year returns on arbitrage funds (around 6-7%) have been somewhat underwhelming. Is this because of too much money chasing arbitrage opportunities? Is there any reason for us to expect an uptick in returns from this category going forward?

Karthikraaj: The returns of arbitrage funds are largely linked to prevailing interest rates and arbitrage opportunities in the market. Arbitrage opportunity is determined by strong trends in the market. As interest rates have been coming down the returns of these funds are reflecting a similar trend.

WF: Will you consider a pure play long/short fund - where the entire corpus is dedicated to the long/short theme? Are there regulatory constraints to this structure?

Karthikraaj: As the regulator stipulates that cumulative gross exposure through debt and money market instruments, equity & equity related instruments, and derivative instruments will not exceed 100% of the net assets of the Scheme, a pure play long/ short strategy may not be an apt product on the mutual fund platform.

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