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The Kotak MF note also highlighted that the arbitrage industry has swelled to a significant size of the total open interest. (Photo: iStock)
The Kotak MF note also highlighted that the arbitrage industry has swelled to a significant size of the total open interest. (Photo: iStock)

Kotak Mutual Fund issues warning on arbitrage spreads

  • Arbitrage funds invest at least 65% of their assets in stocks and at the same time sell their futures, thus generating a return from the spread between spot and futures prices.

Average arbitrage spreads turned negative for the first time in a decade, Kotak Mutual Fund has said in a note to distributors. A spread is a difference between the price of a stock and the price of its futures contract. Arbitrage funds, a category of a mutual fund, 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.

Arbitrage funds invest at least 65% of their assets in stocks and at the same time sell their futures, thus generating a return from the spread between spot and futures prices. A small part of arbitrage funds (around 20-30%) is invested in debt and this will cushion returns. The Kotak MF note also highlighted that the arbitrage industry has swelled to a significant size of the total open interest (its target market), implying that this leaves less opportunity on the table for such funds.

This is because there needs to be sufficient interest from foreign institutional investors and high networth individuals (HNIs) in stock futures to keep them elevated relative to spot prices, and thus keeping the spread alive. The arbitrage industry pegged at 65,000 crore is currently a large part of the arbitrage market of 80,700 crore, according to the note.

The market consists of various entities like arbitrage funds, foreign institutional investors, domestic institutional investors and HNIs. The arbitrage industry is largely arbitrage funds and they do not buy futures to speculate unlike the other three. So the presence and size of the other three do matter compared to the size of arbitrage funds to balance the market.

Compression in arbitrage spreads had previously hit the mutual fund industry at the end of March, causing some fund houses such as ICICI Prudential AMC and Tata Mutual Fund to temporarily halt inflows. Nilesh Shah, CEO of Kotak Mutual Fund declined to say whether Kotak Mutual Fund will also stop inflows but added that the decision to gate flows will be purely a function of market opportunity.

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 headwind, 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. “This negative spread places the recent rally in question," said Nithin Sasikumar, co-founder of Investography, a financial planning firm.

On the positive side, Kotak Mutual Fund said that returns have been higher than rollover returns in the last couple of expiries due to higher volatility in the equity market. Thus a compression of spreads at the start of the month may not necessarily imply poor returns throughout the month. Investors should also increase their time horizon in this category from three to six months, it added.

“I think this is seasonal. Hence we always say three-month money should come in. You should not use an arbitrage fund as a liquid fund," said Radhika Gupta, CEO, Edelweiss Mutual Fund. Investors should keep this in mind while investing in arbitrage funds.

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