Arbitrage Funds - A Review

Arbitrage Funds - In Indian MF space, this category of funds is supposed to participate in plain simple Cash-Future arbitrage play (almost 65-70%) & in fixed income instruments (30-35%) without taking any undue credit or duration risk. Here, in the chart attached, we have depicted monthly returns (annualised) of top seven Arbitrage Funds, based on AuM. First time in history, this month (Jun'20), we saw all Arbitrage Funds with negative return. Whether one considers this monthly return - based on calendar month or expiry to expiry - considering either case, this monthly performance of all arbitrage funds has been in negative territory. Surprising - isn't it?

Reasons for poor performance

1. The returns were advanced into previous month number - May'20.

2. AuM of Arbitrage Funds has improved almost 35-40% since Mar'20, for this select basket of Arbitrage funds. So more supply of money for limited opportunities.

3. The sharp increase in margins on stock futures over the last three months, has caused the HNI/ AIF/Retail activity to shift to the options market from the futures market, thereby putting pressure on participation in the futures market. Limited opportunity for Arbitrage funds to set positions of short futures.

4. Given the increase in stock volatility, FPI/FII trading has shifted to the Index futures from stock futures and their absence from the stock futures market is impacting liquidity.

5. Also, the exchange has reduced the size of positions that individual entities can take in single stocks, thereby limiting balanced participation from various market participants.

6. FD rates / overall yield curve has been softening over last few months, thereby causing pressure on returns from arbitrage funds, as almost 35% of AuM is locked in fixed income instruments.

Points 3-4-5-6 are relatively little medium term in nature.

Overall, this category of fund has self-correcting (Adam Smith's invisible hands) phenomenon built into it. Higher return attracts more funds from Liquid & UST Debt Funds to this category and vice-a-versa. While almost all arbitrage funds have given negative return in last month - we have already hit the bottom of cycle. However, AuM of this category has increased by almost 5% in last month and almost 35-40% up from Mar'20 (after lock-down correction in AuM).

Going forward we need to keep watch on 2 factors -

1. In case of continuation of sub-optimal arbitrage spreads, let's face some exodus of funds from Arbitrage Funds to Liquid & Ultra Short Term Funds. AuM should drop and that means lesser money will chase arbitrage opportunity in the industry (which is also indirectly related to expected return in Liquid Funds & UST Funds).

2. Overall volatility in futures market is important parameter to watch. As volatility drops, over the medium term, there could be lower margins requirements and relaxation in positions in individual stocks and more players returning to Futures from Option markets – all these could improve arbitrage spreads.

So let's a keep watch.

02jul20