Arbitrage MFs’ Record Run may Hit Poll Bump, Experts Favour Caution

Analyzing the Recent Rush into Arbitrage Mutual Funds in India and Impacts Across Industries and for Different Types of Investors

Source and Citation: Originally reported in ET Bureau, January 2024, summarized and analyzed here.

Table of Contents

Analysis for a Layman

Arbitrage funds witnessed massive monthly inflows of over ₹10,000 crore in December 2023, the highest since mid-2021. These specialized mutual funds aim to profit from the price difference between a stock’s price on spot markets versus futures markets.

In recent years, returns for arbitrage funds have improved from 3-4% to 7-7.5% as markets rallied. They offer favorable tax treatment akin to equity funds, making post-tax returns attractive compared to fixed deposits or other debt funds. This explains the rising interest from retail investors, HNIs, and institutions.

However, experts advise caution looking ahead to 2024. As a national election year, volatility is expected which can impact arbitrage fund returns. There are also indications balanced advantage funds, which allocate over 15% into arbitrage schemes, may shift more assets toward equities if markets correct. This could spark outflows.

In summary, arbitrage fund returns are tied to spot-future spreads and broader market direction. The rush of inflows in 2023 corresponded with bullish sentiment that boosted profits. But looking into 2024, experts are preaching prudence amid likely turbulence.

Impact on Retail Investors

For retail investors, arbitrage funds can play a portfolio diversification role similar to low-risk debt funds, but with the tax efficiency of equity products. This explains part of their recent appeal.

In the short term, retail investors may continue chasing recent strong returns in arbitrage funds. However, they should understand these schemes do carry risks and are not guaranteed to outperform fixed deposits or liquid funds during market downturns.

The core strategy relies on spot-futures arbitrage opportunities which can diminish if volatility spikes, eroding returns. There is also interest rate risk associated with the short-term corporate debt securities held to cover futures positions.

Further, the indication that balanced advantage funds may reallocate toward equities in a weak market could spark a rush of outflows from arbitrage schemes. Retail investors could get caught in the redemption wave.

Over a long term investment horizon, arbitrage funds can generate moderate fixed income-like returns with preferential tax treatment. But expectations need to be tempered, and investors should be aware these are not fixed return assurances.

Rather than chasing recent performance, retail investors should evaluate arbitrage funds as a small allocation complementing their core equity and debt holdings. The tax advantage makes them efficient fixed income replacements, but expectations on yields need calibration along with risk monitoring.

Impact on Industries

The mutual fund industry remains the clearest beneficiary of surging inflows into arbitrage funds. Continued interest through 2023 has allowed fund houses to build sizable arbitrage-focused assets under management (AUM). They earn fees based on these AUMs.

However, the indication that volatility may return in 2024 could put pressure on arbitrage profits. If balanced advantage funds rebalance away, sudden outflows would shrink AUMs and bite into management fees.

For companies with dual listings across spot and futures exchanges, arbitrage trading activity aids price discovery and liquidity. Funds exploiting small pricing inefficiencies generate volume and smoothens spreads. This increases trading interest from other participants.

In periods of elevated volatility though, the arbitrage-related activity could drop rapidly or funds may be forced to trade more selectively. This could impact liquidity and widen spreads temporarily for dual listed stocks until other market participants fill gaps.

Broader industries will be influenced indirectly by investor asset movements in or out of arbitrage funds depending on market conditions. If funds face redemptions, they may need to sell stakes in short-term debt instruments impacting credit markets. Meanwhile beneficiaries of reallocated balanced advantage fund flows would see upside.

So while arbitrage fund activity has indirectly supported more efficient stock and bond markets, extreme risk-on or risk-off moves can create ripple effects. Companies and industries may feel temporary liquidity impacts, positive or negative.

Long Term Benefits & Negatives

Over longer term horizons, the proliferation of arbitrage funds built on spot-futures imbalances has strengthened overall capital market infrastructure in India. Arbitrageurs add liquidity, aid price discovery, and smooth inefficiencies – benefiting companies and investors.

With arbitrage AUMs swelling after years of positive momentum, fund houses have greater latitude to expand product lines and attract investor assets through market cycles. They can hire talent and promote arbitrage as a specialized skillset within the asset management industry.

For listed companies, arbitrage trading activity centered around dual listings deepens pools of capital and secondary market interest. More efficient stock pricing and reduced volatility in spreads allows corporates to optimize equity issuances and capital planning.

However, several negative implications emerge over long horizons if market dynamics shift against arbitrage strategies. Sustained volatility curbing arbitrage profitability could see sharp AUM declines. Building specialized teams and infra around these schemes may then have diminishing value.

For listed companies who have benefited from arbitrage activity smoothing spreads and aiding price discovery, a structural decline could negatively impact liquidity and pricing efficiency. If arbitrage capital vanishes, they may see wider spot-futures spreads and higher equity costs.

Finally, if balanced advantage funds reorient away from arbitrage allocations long term, the schemes could lose a stable pillar of capital support. This would leave them more exposed to general retail and institutional investor sentiment. Larger outflows would ensue in periods of market stress without balanced fund asset buffers.

Short Term Benefits & Negatives

In the near term, assuming markets extend their buoyancy, arbitrage funds look likely to continue benefiting from bullish trading conditions and positive investor interest. This short term momentum would sustain the rapid AUM growth recent fund houses have relied upon.

With asset totals swollen entering 2024, management fees may reach new highs in early months of the year – even if volatility rises. However, sustained volatility eating into spreads by mid-2024 would trim profits and could spark the balanced fund outflows that advisers have cautioned about.

For arbitrage fund managers, a key priority may be attempting to retain balanced advantage fund clients even as they reorient toward equities amid Election cycle swings. Keeping even a fraction of those sticky assets could help avoid the harshest potential AUM drops.

In an immediate sense, listed firms will continue enjoying the liquidity and pricing benefits funded by swollen arbitrage AUMs. But by mid-2024, if redemptions spike sharply, there is high probability of adverse impacts – wider spreads, higher volatility, diminished liquidity at least for a quarter or two as arbitrage fund positions rapidly unwind.

Potential Impact of Increased Arbitrage Fund Inflows:

Indian Companies:

Gaining:

Arbitrage Fund Management Companies:
- Reliance Mutual Fund, ICICI Prudential Mutual Fund, HDFC Mutual Fund: Increased inflows lead to higher AUM and revenue through management fees.
- UTI Mutual Fund, Nippon India Mutual Fund: Improved market share and brand recognition in the arbitrage fund niche.
Brokers and Market Intermediaries:
- IIFL, Edelweiss, Motilal Oswal: Higher trading volume due to arbitrage activities generates brokerage fees and income.
- Zerodha, Upstox: Increased retail participation in arbitrage funds creates new client base and trading activity.
Companies with High Volatility Stocks:
- Adani Group, Tata Motors, YES Bank: Potential for higher price discovery and improved liquidity due to arbitrage activities.

Losing:

Debt Mutual Funds:
- Franklin Templeton, Axis Mutual Fund, BNP Paribas: Competition for investor funds with potentially higher returns from arbitrage funds.
- Fixed Income Funds, Bond Funds: Outflows may occur if investors seek risk-adjusted arbitrage returns over fixed income options.
Fixed Deposit Accounts:
- State Bank of India, ICICI Bank, HDFC Bank: Reduced attractiveness for risk-averse investors seeking guaranteed returns compared to arbitrage funds.
- Small Savings Schemes: Lower inflows if arbitrage funds offer similar post-tax returns with potentially higher liquidity.

Global Companies: