Why are arbitrage mutual funds holding debt mutual funds in their portfolios?

Published: October 12, 2022 at 6:00 am

A reader asks, “I noticed that Kotak Arbitrage Fund is holding about 5% of Kotak Liquid Fund. Can you explain why they are doing this?”

Kotak is not alone. Many arbitrage funds buy units of their own debt funds. This is done in a bid to bolster returns. Even a few years back, arbitrage funds could hold about 90% of derivatives and generate returns close to fixed deposits. Arbitrage opportunities have gradually decreased, perhaps due to stabilization of the stock market with increased domestic institutional presence.

After the SEBI categorization rules came into play in mid-2018, Arbitrage funds were reclassified as hybrid funds. They only need to hold 65% of equity and equity-related instruments (derivatives). The rest can be in bonds, cash and related instruments. This allowed mutual funds ample room to buy debt funds units freely (this practice existed even before the rule change).

List of arbitrage mutual funds holding mutual funds units as of Aug 31st 2022

17 out of 26 funds in this category are listed below. The exposure significantly varies from AMC to AMC.

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    Scheme Name (names of funds holding more than one fund will be repeated)Company NameHolding(%) Aug 2022
    Aditya Birla SL Arbitrage Fund(G)Aditya Birla SL Money Manager Fund(G)-Direct Plan26.6659
    Aditya Birla SL Arbitrage Fund(G)Aditya Birla SL Floating Rate Fund(G)-Direct Plan1.1833
    Axis Arbitrage Fund-Reg(G)Axis Ultra Short Term Fund(G)-Direct Plan7.8089
    Axis Arbitrage Fund-Reg(G)Axis Money Market Fund(G)-Direct Plan7.4410
    Axis Arbitrage Fund-Reg(G)Axis Liquid Fund(G)-Direct Plan3.8964
    DSP Arbitrage Fund-Reg(G)DSP Savings Fund(G)-Direct Plan0.0957
    HDFC Arbitrage-WP(G)HDFC Money Market Fund(G)-Direct Plan8.4323
    HDFC Arbitrage-WP(G)HDFC Liquid Fund(G)-Direct Plan7.6369
    ICICI Pru Equity-Arbitrage Fund(G)ICICI Pru Savings Fund(G)-Direct Plan6.3655
    IDFC Arbitrage Fund-Reg(G)IDFC Cash Fund(G)-Direct Plan6.6381
    Invesco India Arbitrage Fund(G)Invesco India Liquid Fund(G)-Direct Plan21.7899
    Kotak Equity Arbitrage Fund(G)Kotak Money Market Fund(G)-Direct Plan11.9437
    Kotak Equity Arbitrage Fund(G)Kotak Liquid Fund(G)-Direct Plan5.6577
    Kotak Equity Arbitrage Fund(G)Kotak Savings Fund(G)-Direct Plan5.6427
    L&T Arbitrage Opp Fund-Reg(G)L&T Liquid Fund(G)-Direct Plan0.9729
    LIC MF Arbitrage Fund-Reg(G)LIC MF Liquid Fund(G)-Direct Plan25.3797
    Mahindra Manulife Arbitrage Yojana-Reg(G)Mahindra Manulife Liquid Fund(G)-Direct Plan22.1402
    Nippon India Arbitrage Fund(G)Nippon India Money Market Fund(G)-Direct Plan7.6264
    Nippon India Arbitrage Fund(G)Nippon India Liquid Fund(G)-Direct Plan4.8640
    Nippon India Arbitrage Fund(G)Nippon India Low Duration Fund(G)-Direct Plan3.9042
    PGIM India Arbitrage Fund-Reg(G)PGIM India Liquid Fund(G)-Direct Plan19.2772
    SBI Arbitrage Opportunities Fund-Reg(G)SBI Savings Fund(G)-Direct Plan13.8360
    Sundaram Arbitrage Fund(G)Sundaram Liquid Fund(G)-Direct Plan11.0610
    Tata Arbitrage Fund-Reg(G)Tata Money Market Fund(G)-Direct Plan11.2582
    Tata Arbitrage Fund-Reg(G)Tata Liquid Fund(G)-Direct Plan3.7860
    Tata Arbitrage Fund-Reg(G)Tata Treasury Advantage Fund(G)-Direct Plan3.1187
    Tata Arbitrage Fund-Reg(G)Tata Ultra Short Term Fund(G)-Direct Plan1.0372
    Union Arbitrage Fund-Reg(G)Union Liquid Fund(G)-Direct Plan13.8952

    List of arbitrage funds not holding mutual fund units as of Aug 31st 2022 (this does not mean they have never held or will never hold such units!)

    1. Bank of India Arbitrage Fund
    2. Baroda BNP Paribas Arbitrage Fund
    3. Edelweiss Arbitrage Fund-Reg(G)
    4. Indiabulls Arbitrage Fund
    5. ITI Arbitrage Fund
    6. JM Arbitrage Fund
    7. Mirae Asset Arbitrage Fund
    8. NJ Arbitrage Fund
    9. UTI Arbitrage Fund

    Is this in the best interest of arbitrage fund unitholders? No, it is not. A chunk of their money is used to pay for expenses of the purchased debt fund, lowering returns. More importantly, it increases the risk of holding the arbitrage fund if the debt fund suffers a credit event.

    If the AMC is “small” in size, the arbitrage fund could be the biggest holder of the debt fund, increasing the redemption risk of both funds.

    AMCs would argue that the underlying holdings would result in better return stability of the arbitrage fund. However, there are ways to achieve this via bonds. It is acceptable for a fund of funds to do this as it is within their mandate to buy other funds. However, an arbitrage fund is not a fund of funds.

    It is bad enough that SEBI has rendered this category style impure by making it a hybrid. Allowing arbitrage funds to buy other debt funds only increases the hidden risk. Although it is legal, we hope that SEBI considers imposing a holding limit for mutual fund units in arbitrage fund portfolios.

    Investors do not need to fear arbitrage funds or exit them because of this. However,  we recommend existing and potential investors in arbitrage funds investigate the historical portfolio holdings of such funds to appreciate underlying risks.

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