A 10 per cent annual return from an equity investment, virtually risk-free, known at the time of making the investment. It is possible to earn this return, that too on a regular basis, by doing arbitrage between the cash market and the futures market. And now, thanks to the newest class of funds whose USP is cashing in on such price differentials, it’s within reach of your modest means.

Although these derivative funds invest in equity instruments, they are classified as a debt fund, as their aim is to protect principal and generate returns at very low risk. However, what makes them unique is that their returns don’t correspond to their very low tolerance for risk. Unlike short-term funds, which return 4-6 per cent in normal times, these derivative funds are capable of returning twice as much.

A derivative fund is not concerned with whether prices are going up or down. Its money-making strategy revolves around looking for reasonably profitable price differentials in the cash and futures prices in the stocks where derivative trading is allowed. When it finds such a situation, it will buy a company’s share and simultaneously sell its futures, and pocket the spread. For instance, at 3.30 pm on January 2, a share could be bought for Rs 367.15. That same moment, its futures (expiry date January 29) could be sold for Rs 370.50, or a premium of 0.91 percent. The fund effectively take two exactly opposite positions, which cancels out on the day of settlement of the futures contract, as the cash and futures prices converge.

Regardless of which way the share price moves, the fund makes a profit. This is equal to the difference in prices at the time of buying, minus transaction costs. The above trade, for instance, gave a return of 0.91 percent for 27 days (January 2-29), or an annualized 11.5 per cent. Net of transaction costs (brokerage, DP charges and securities transaction tax), the annualized return from this trade works out to 8.0 per cent. It’s near risk-free return and it is known at the time of making the trade.

Such price differentials are available all the time. On a steady trading day, about 10 of the stocks on which derivatives trading is allowed offer a net arbitrage return of 7 percent. In volatile markets, this can go up to 12-15 percent. That’s a top risk-free return. However, even if a derivative fund manages to make such arbitrage gains, its overall return will be lower. That’s because it has to invest at least 25% of its corpus in low-yielding money market instruments. Under current SEBI norms, mutual funds can’t invest more than 50 per cent of their corpus in derivatives. If a derivative fund is to take a perfect hedge to stay risk-free, as well as pay the margin money on its future positions, its equity exposure (spot plus futures) will get capped at about 75 percent. The balance will be invested in money market instruments, which will lower its returns. Effectively, you get at least money market returns – and a reasonable shot at doubling it without putting your capital at risk.

In such funds speed is of the essence, as funds need to be quick to capitalize on price differentials. That task is made simpler by trading softwares, which are programmed to identify, even execute, such trades.

Perfect as this fund seems, it is not. There are minor irritants for you as well as your fund. Unlike traditional schemes, you can’t exit freely, and payment doesn’t always happen within 48 hours. Both the derivative funds have small lock-ins. In many funds, redemption is allowed on only one day in the month. So, you should park only those funds on which you can wait to withdraw.

A systemic shortcoming induces a small element of subjectivity and risk for these funds. At present, stock futures are settled by squaring off, rather than through delivery of shares. A derivative fund banks on the cash and futures price converging for it to pocket the buying spread. But, on the contract expiry date, there can be a mismatch between the settlement price in the cash market, which can go against the fund.

A derivative fund sells its shares just before market closing. But the settlement price for its futures contract is known only after the trading session, as the exchanges take the weighted average of traded price in the last 30 minutes of trading. If the stock in question has seen a sharp rise or fall in prices during this period, its original price differential can get eroded.

As trading volumes increase, and more players track this space, the number of arbitrage opportunities – and returns – might reduce.