Arbitrage Fund & factors Influencing its NAV

Arbitrage fund is a type of Hybrid Mutual Fund category, which create returns through the purchase and sale of securities in different markets to get the benefit of price mismatch.

This fund is best suitable to investors who want to profit from volatile markets without taking on too much risk.

Usually, arbitrage funds buys securities from the stock market and sell the same on futures contracts market at a high price to generate profit from the transaction. Since arbitrage funds are a type of equity-oriented hybrid funds, they also invest in short-term debt and money market instruments.

Arbitrage funds invest at least 65% and maximum 80% of their assets in Equity & Equity Derivatives. A small part of arbitrage funds (around 20-30%) is invested in debt and this will cushion returns.

The margin money requirement for the purposes of derivative exposure will be held in the form of Term Deposit.

Whenever the equity and equity derivative investment strategy is not likely to give return comparable with the fixed income securities portfolio, the fund manager will invest in fixed income securities.

Factors influencing NAV of Arbitrage Funds

As we can see from the graph that there is continuous upside movement of NAV since June 2019, but we can see a sudden volatility since March 2020. To understand factors we first needs to understand the spread

Returns of arbitrage funds are dependent on Spreads. A spread is a difference between the price of a stock and the price of its futures contract. Arbitrage funds, deliver returns from positive arbitrage spreads. A fall in the spread or a negative spread makes future return generation difficult, at least in the short term.

The above chart is prepared by plotting the positive price difference between the closing rates of NIFTY 50 Futures and NIFTY 50.

Factors impacting Spread

Sentiments in equity markets:

Arbitrage funds do well in volatile markets (with bullish sentiment) because that’s when profitable arbitrage opportunities are easily available. In bullish markets – FIIs, HNIs and retail investors increase their participation in the Futures & Options segment to take leveraged long bets. This increases the spread for short rollers like arbitrage funds.

Size of the industry – bigger not better

As arbitrage funds grow their assets under management, the quantum of money scouting for arbitrage opportunities goes up and the spreads (and so the returns) tend to go down.

At its peak, the arbitrage industry (65% of the AUM of all arbitrage funds that is in cash-futures arbitrage) accounted for half of the Rs. 1.1 lakh crore arbitrage market (measured by the total stock futures open interest).

Lower domestic interest rates

As interest rates fall, arbitrage returns too are likely to fall. Due to following reasons

• Investors going long on futures (who are responsible for the premium spread) can now borrow at a lower cost and hence take larger positions with the borrowed money leading to lower premium in futures.

• When interest rates come down then future debt fund return potential also comes down. But if the arbitrage spreads continue to be high, then money will move from debt funds to arbitrage funds, leading to more money chasing the same arbitrage opportunities and hence eventually leading to lower spreads and returns subsequently.

FIIs – currency hedging and borrowing costs matter

Lower INR hedging cost and borrowing cost reduce the arbitrage thresholds for FIIs, increasing their participation in the Indian equity arbitrage trades and consequently bringing down the spreads.

These Factors have created steep increase in Open Interest during May, 2020

Open interest is the total number of futures contracts held by market participants at the end of the trading day. It is used as an indicator to determine market sentiment and the strength behind price trends The arbitrage industry has expanded to a significant size of the total open interest (its target market), implying that this leaves less opportunity for such funds

NAV Movement in relation to spreads

As seen from the above graph, there is an increase in NAV in response to increase in spread, and the NAV reduces due to less spread opportunity. returns have been higher than rollover returns in the last couple of expiries due to higher volatility in the equity market. Arbitrage funds typically give returns in line with short-term interest rates. These have been falling steadily on the back of successive rate cuts and liquidity easing measures by the Reserve Bank of India (RBI). However, on top of this, arbitrage funds are also affected by overall sentiment in the market. In times of extreme bearishness, the spread between spot and futures prices, which arbitrage funds capitalize on, can fall to zero or even turn negative. A compression of spreads at the start of the month may not necessarily imply poor returns throughout the month. Hence, the ideal time horizon to stay invested should be 3 to 6 months or more.

Disclaimer

NAV of ICICI Prudential Equity Arbitrage Fund is taken for explanatory purpose only

Data gathered from the website of NSE, ICICI Pru AMC, and other relevant websites

Interpretation of data may not be accurate; efforts were made to simplify concept/ factors which affects the NAV of Arbitrage Funds

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. The NAVs of the schemes may go up or down depending upon the factors and forces affecting the securities market including the fluctuations in the interest rates. The past performance of the mutual funds is not necessarily indicative of future performance of the schemes. The Mutual Fund is not guaranteeing or assuring any dividend under any of the schemes and the same is subject to the availability and adequacy of distributable surplus. Investors are requested to review the prospectus carefully and obtain expert professional advice with regard to specific legal, tax and financial implications of the investment/participation in the scheme.