Arbitrage Funds

Analysis of Arbitrage Funds and Their Increased Retail Participation

Source: The analysis is based on information from an article by Prashant Mahesh published on January 3, 2024.

Analysis for a Layman

Arbitrage funds operate by exploiting temporary price differences between the equity spot and futures markets to generate returns. For instance, if a stock trades at Rs 2000 in the cash market and Rs 2020 in the futures market, the fund manager can profit by simultaneously buying the stock in the cash market and selling an equivalent futures contract, earning the Rs 20 price arbitrage spread per share.

The appeal of these funds has grown as stock market volatility increased amid record highs. Regulatory norms mandate allocating a minimum of 65% of the fund corpus to such arbitrage opportunities and the remainder to debt investments.

With assets under management in arbitrage funds rising 60% in a year to Rs 1.38 lakh crore, more investors are allocating some corpus here given the reasonable returns potential at lower risk than equity funds. But availability of sufficient arbitrage opportunities on a consistent basis across market conditions determines actual returns generated.

Impact on Retail Investors

For retail investors, arbitrage funds offer a relatively safe option to benefit from indirect equity market participation. By harnessing pricing differentials rather than outright equity directional exposure, some equity-linked returns are accessible without the sharp volatility and loss risks associated with stocks or equity mutual funds.

Those with moderately high risk appetite can consider 10-15% of their mutual fund portfolio allocation into arbitrage funds given current dynamics. Potential 7-9% returns help balance against pure debt funds without too much risk of negative returns in most conditions. It also simplifies taxation for investors compared to hybrid equity-oriented balanced advantage funds.

However, expectations have to be monitored based on market trends. In case the high volatility phase subsides over the next year leading to less mispricing between spot and derivatives, arbitrage funds returns could moderate closer to conservative debt fund returns. So consumer education on actual model dynamics remains vital.

Impact on Industries

AMC Industry:

• Rising arbitrage fund interest helps leading fund houses like ICICI Prudential, Edelweiss, Kotak Mahindra, HDFC Asset Management etc. augment their equity-oriented mutual fund AUMs without investors facing significant direct drawdown risks inherent in pure equity funds. This expands the target customer base beyond aggressive risk-takers.

Wealth Management:

• For wealth managers, arbitrage funds allow constructing a balanced portfolio asset allocation more seamlessly without client skepticism associated with equity exposure. Risk positioning is optimal.

Derivatives Trading:

• Higher arbitrage fund activity translates into greater trading volumes for brokerages and derivatives exchange platforms through associated hedging of futures positions. Boosts transaction fees earnings ecosystem.

In summary, arbitrage funds positively impact the mutual fund provider industry, wealth management practice, and derivatives trading ecosystem owing to current market dynamics.

Long Term Benefits & Negatives

Positives:

1. Risk Management: The mechanism structurally curbs loss potential compared to outright equity funds. Positive for democratizing market participation.
2. Ease of Access: Simple mutual fund structure and seamless investment compared to directly identifying arbitrage opportunities attract a growing retail base.
3. Tax Advantages: Preferential tax treatment aids investor experience and post-tax returns profile relative to comparable fixed income options.

Negatives:

1. Low Transparency on Actual Exposure: Indirect derivative hedging makes understanding the live portfolio construct challenging for lay investors unlike physical shares or bonds.
2. Limitations in Scale: The universe of stocks with sufficiently liquid derivatives to hedge large-scale arbitrage strategies remains restricted currently. Hampers exponential growth potential.
3. Spot-Futures Convergence: Gradual efficiency enhancement may reduce widespread price differentials accessible limiting fund manager flexibility on spreads captured over the long term.

Thus while beneficial directionally, optimizing stability, simplicity, and transparency factors can determine the sustainability of arbitrage funds’ rising prominence.

Short Term Benefits & Negatives

Positives:

1. Channel Incentives: Attractiveness of arbitrage funds propositions incentivizes distributors and relationship managers to amplify awareness further via campaigns.
2. Investor Sentiment Catalyst: Visible returns act as a positive trigger for dormant investors to reactivate equity-oriented market participation following years of skepticism. Reinforcing effect on investor confidence at market highs.

Negatives:

1. Misselling Triggers: In chasing higher assets under management, misselling under the garb of low-risk funds to conservative fixed income investors could attract regulatory glare. Sophistication assumed is higher.
2. Fee Pressures: Higher expense ratios charged compared to debt funds may come under scrutiny as more institutional money also starts chasing arbitrage strategies allowing scale efficiencies for fund houses. Value proposition has to be maintained.
3. Elevated Unrealistic Expectations: Many investors could extrapolate high historical returns guidance to underestimate the impact of declining arbitrage opportunities if volatility stabilizes over 2023-24. Probability not communicated prudently.

Thus investors, distributors, and fund managers need balanced education on realistically sustainable arbitrage funds return prospects as volatility trends evolve amid market highs.

Companies Impacted by Rising Popularity of Arbitrage Funds:

Indian Companies:

• Gainers:
  • Mutual Fund Houses: Increased investor interest in arbitrage funds could benefit all mutual fund houses with significant offerings in this category, such as HDFC MF, UTI MF, ICICI Prudential MF, and Kotak Mahindra MF. Higher AUMs and inflows could generate increased management fees and boost their profitability.
  • Stock Exchanges and Clearing Corporations: NSE and BSE might see increased trading volume in both cash and futures segments due to higher arbitrage activity, potentially leading to higher fee income. Clearing corporations like MCX Clearing might also benefit from increased transaction volume.
  • High-Net-Worth Individuals (HNWIs): The tax advantage of arbitrage funds compared to debt funds makes them particularly attractive for HNWI investors seeking tax-efficient returns. Wealth management firms catering to HNIs could see increased demand for arbitrage fund investment strategies.
• Neutral:
  • Banks: While some investors might shift part of their savings from bank accounts to arbitrage funds, the overall impact on bank deposits is likely to be muted as arbitrage funds cater to a different risk appetite segment.

Global Companies:

• Limited Impact:
  • Global Asset Management Firms: While the growth of the Indian arbitrage fund market might offer potential growth opportunities in the long term, the market remains primarily domestic and unlikely to significantly impact global players in the near future.
  • Foreign Institutional Investors (FIIs): The increased activity in the futures market might indirectly benefit FIIs by providing higher liquidity and potentially smoother execution of their trading strategies.

Market Sentiment:

• Positive: The news could generate a positive sentiment towards the Indian mutual fund industry and equity markets in general.
  • Mutual fund houses with strong arbitrage fund offerings might see increased investor interest and potentially higher stock prices.
  • Increased activity in the cash and futures market could be interpreted as a sign of market confidence and potentially boost overall market sentiment.
• Neutral: The impact on broader market sectors and individual companies is likely to be limited and dependent on other economic factors and global markets.

Note: This analysis is based on limited information and may not capture all factors. Conduct further research and consider your individual circumstances before making any investment decisions.