Market inefficiencies and higher than normal market volatility results in profitable arbitrage opportunities

For a layperson who doesn't know what is arbitrage fund, how would you explain it to them?

An Arbitrage fund aims to provide relatively risk-free return by identifying potential profitable opportunities of arbitrage between the cash and derivatives market. Arbitrage funds are mutual funds that aim to generate profit from price differential in the derivatives and cash market through simultaneous buy & sell transactions in cash and futures or vice - versa in market respectively. The scheme hence always runs a hedged position in equities. A minimum of 65% is always invested in such cash-futures arbitrage, with the balance invested in debt and money market securities, including for margin purposes.

With such funds employing arbitrage opportunities, is finding arbitrage opportunities easy or is it becoming more seasonal now? (i.e., when markets show more volatility, its easier to find opportunities)

Finding arbitrage opportunities depends on various factors like market efficiency, volatility, liquidity, and the overall macroeconomic environment. During economic uncertainty, market volatility tends to be on the higher side potentially increasing the arbitrage opportunities. During stable market environment, existence of highly potential arbitrage opportunities is on the lower side.

What key metrics should investors consider while investing in an arbitrage fund?

Though the past returns are not an indication for future returns, investors investing in an arbitrage fund should consider factors i.e., risk appetite, tax planning and investment horizon. Arbitrage funds are relatively low risk funds and taxed as equity funds having lower capital gain tax rates. The investment horizon should be minimum 6 months to earn reasonable returns.

Investor should also check the past performance, expense ratios, tracking error, portfolio allocation towards debt and equity, exit loads to reap optimal returns.

What are the challenges of investing that you see in arbitrage strategy?

Market volatility and Market efficiency are the two risks I see in arbitrage strategy. In a gloomy market scenario, futures may trade at a discount to the spot price thereby nullifying arbitrage opportunities that are otherwise available. When market becomes efficient with the advent in technology and trade execution, identifying and capitalizing on potential arbitrage becomes challenging.

What is your view on the markets going forward? Which sectors do you have more volatility in, thus creating arbitrage opportunities?

Markets look forward to first & second quarter of FY24 earnings. Inflationary dynamics and the global central bank’s response to that will play a role in identifying potential and profitable arbitrage opportunities. Locally, we will be keenly watching El Nino and its impact on monsoon and inflation. We do not have sector specific views. We are sector agnostic in identifying arbitrage opportunities. We would want to continue that way.

Please explain why arbitrage funds tend to give higher returns in certain market conditions and what those conditions are?

Market inefficiencies and higher than normal market volatility results in profitable arbitrage opportunities. Corporate actions also provide attractive arbitrage opportunities. The potential profitable arbitrage during these periods is higher compared to stable market conditions.

In your view, can arbitrage funds give relatively higher returns in current market conditions?

As discussed earlier, macro-economic events, market volatility, impact of El Nino on monsoon and its effect on inflation and global central bank’s response to inflationary dynamics will play a huge role in potential arbitrage opportunities. Quarterly earnings of FY24 will play a role too.

Eventually the returns in the arbitrage strategy tracks the short-term interest rates in the economy. In view of the current interest rate stance, it is expected that the short-term rates in the system may stay elevated in the near term. Short term rates are also influenced by the system liquidity and the resultant volatility in the same. In the near term, even as system liquidity remains in surplus, the RBI actions to drain excess liquidity and government tax outflows can continue to keep rates volatile and relatively elevated.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully