Arbitrage mutual fund returns reduce due to negative spreads

Published: July 25, 2020 at 10:47 am

Last Updated on December 29, 2021 at 5:39 pm

Those who argue that the stock market recovery is not to be trusted can use the Nifty 50 Arbitrage Index for support. The index that tracks the price difference between “buying equities and selling equivalent equity futures” has registered a fall over the last three months (13 weeks to be exact). Pointing to a drying up of arbitrage opportunities. As a result, arbitrage mutual fund returns have gone down. What investors need to know.

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Arbitrage mutual fund profit from the price difference between the spot market and the futures market. This gap, known as a spread, is usually positive (future price > spot price) but can become negative in bear markets. It occurred after the 2008 crash and now after the 2020 crash.

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When this happens, mutual funds tend to stop fresh inflows. It occurred in July 2009 and briefly in March-April 2020 (ICICI, Tata AMCs). This is a temporary phenomenon that can last over a few months or more. Naturally, this would affect the sequence of returns over the coming months. The Nifty arbitrage index has recovered over the last month (see table below).

The reduction in arbitrage spread can be seen below in the price movement of Kotak Arbitrage Fund and Nifty 50 Arbitrage Index. The reason why arbitrage mutual funds have not suffered as much is because of their bond holding (up to 35%).

Price movement of Kotak Equirty Arbitrage Fund and Nifty 50 Arbitrage Index since 1st July 2019
The price movement of Kotak Equity Arbitrage Fund and Nifty 50 Arbitrage Index since 1st July 2019

Typically they hold short-term bonds, but their returns have also come down in the recent months. See: Overnight Mutual Funds also have risks! What investors need to know

The trailing returns of ICIC Equity Arbitrage, Kotak Equity Arbitrage and Nifty 50 Arbitrage Index is shown below. Arbitrage funds have been saved by the bond holding from negative returns over the last few months (their weekly returns did go negative)

DurationICICI Pru Equity-Arbitrage Fund(G)-Direct PlanKotak Equity Arbitrage Fund(G)-Direct PlanNifty 50 Arbitrage Index
1 Week0.210.200.19
2 Week0.200.200.20
3 Week0.150.120.08
1 Month0.330.270.02
2 Months0.390.45-0.23
3 Months0.960.99-0.33
10 Week0.600.64-0.12
11 Week0.620.67-0.20
12 Week0.830.79-0.25
4 Months2.101.860.60
13 Week0.960.99-0.33
14 Week1.361.390.13
6 Months2.662.650.89
9 Months4.104.092.14
1 Year5.645.673.72

What does this mean? What should investors do? Arbitrage funds should not be used for the short-term. While the losses would not be significant, the mismatch between reality and expectation can be hard to take. Use them for needs above one year.

The lack of participation in the futures market is the reason for this downturn. This happens when there is a financial crisis. It should become better in the coming months. Returns for investors who have been invested for the past few years is likely to dip a little. So better to expect less.

I use ICICI equity arbitrage as part of my emergency fund as in the debt part of my son’s future portfolio (separate folios). The emergency cash (with one withdrawal) has grown at 6.5% over the last four-plus years. I rebalanced out from equity into the arbitrage fund for my son’s future in Dec 2017 and Dec 2019. That now stands at 6.3%. Going forward this should drop a bit, but I am not going to do anything.

We can expect outflows from Arbitrage funds (outflows were reported in March 2020) and reduced inflows in the coming months. This should compensate for the lack/reduced spread. Those who understand risks and use arbitrage funds for the right reason need not be worried (that goes for any investment, duh!)

Let us hope mutual funds are not tempted to take on credit risk to hold on to investors!  Better to keep an eye on monthly factsheets for bond quality.

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