Over the last few months, we have seen significant volatility in the assets of arbitrage funds. While the category saw net outflows of Rs.33,800 crore in March, it has recovered some ground in April and May. However, the AUM of arbitrage funds stood at Rs.69,300 crore in May compared to RS.85,400 in February.
There are two reasons for this volatility in AUM of arbitrage funds – cash flow requirement and misplaced expectations. While it is fine if outflow was due to the first reason, it has to be addressed if outflow is due to misplaced expectations.
Let us first understand how arbitrage funds derive returns
Majority of the returns of arbitrage funds, 65% to be precise, come from the price difference between the cash / spot segment and the stock futures segment of the equity market. Remember that arbitrage funds do not derive their returns from bullish or bearish markets; instead, these funds simply derive returns from the spread between cash and derivative markets which further depends on multiple factors like interest in futures, demand and supply from various segments like traders’ proprietary books, FIIs, mutual funds, etc.
The spread i.e. price differential between spot and futures is volatile and cannot be compared with coupons on bonds. Hence, to the extent of 65% of the portfolio, returns can be more or less volatile than fixed income funds depending on market conditions.
The balance 35% is invested in money market / debt market instruments and cash equivalents.
Is it fair to compare to arbitrage funds with liquid funds?
No. In liquid funds, though there is some mark-to-market impact i.e. returns move in line with the money market levels, most of the returns come from accrual i.e. the maturity of debt instruments in the portfolio. In arbitrage funds, fund managers buy stocks in the cash / spot segment and take short position in the monthly futures contract. To that extent, once a position is taken for a month, returns are more-or-less predictable. However, on the last Thursday of the month i.e. when the contract expires and fund managers take fresh positions, the ‘roll-over’ for the next month may happen at a much higher or lower level than the previous month. Over a long period, say one year, these fluctuations tend to even out. The point is, it requires an adequate investment horizon to compare with liquid funds.
Reason for volatility in arbitrage funds
Due to typical market conditions in March, the spread (i.e. difference between the price in cash and futures segment) dropped significantly. In fact, the category reflected negative returns in some cases. A section of investors would have thought that there is something wrong with the concept of arbitrage itself. That would have led to the exodus mentioned earlier. And that precisely is the point – fluctuations will happen in arbitrage funds in short terms say 3 months
Conclusion
There is no denying that arbitrage funds offer reasonably stable returns (over adequate horizon) and taxation benefits like equity funds. Simply put, you can recommend arbitrage funds only if your clients have an adequate time horizon. For short term needs, liquid and overnight funds make more sense.
Source: https://cafemutual.com/news/guestcolumn/462-is-it-fair-to-compare-to-arbitrage-funds-with-liquid-funds