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Charts & Analysis

Arbitrage Funds: You Don’t Want to be the Elephant in the Room

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This analysis in this post was subsequently referenced in a 2nd July Business Standard article: “Rising shares of arbitrage funds in futures segment weighing on returns

Arbitrage Funds: You Don't Want to be the Elephant in the Room


Arbitrage funds are a strange beast – these funds offer you debt style returns, but invest in stocks. They do that by using a loophole in a tax law, which allows them to be called an equity fund if they own 65% equities.

Two interesting things are happening:

  • Arb Funds are now the Elephant in the “Futures” market
  • Dividends are skewing Arb fund returns

But First, A Quick Look at the Arb Fund Concept

How do they avoid the risk of equities? By taking a “futures” position on the sell side that will usually be priced marginally above the stock price. That difference is realized on the expiry date of the futures (usually the last Thursday of the month). Instead actually realizing the difference, since the mutual fund will still have money, they just “roll over” the futures. You can imagine this is such:

a) Give the fund Rs. 100

b) They buy a stock worth Rs. 65

c) They sell the same stock’s future at say Rs. 66

d) They put the remaining in a fixed deposit and offer as margin against the future sale (some part of the margin must be in cash).

Now at the end of the month, if:

  • The stock is at Rs. 70, they make Rs. 5 on the stock as profit, they lose Rs. 4 on the future, and net make the Rs. 1 as a profit.
  • The stock is at Rs. 50, they lose Rs. 15 on the stock, and they profit at Rs. 16 on the future, which is still a Rs. 1 profit.

No matter where the market goes, the arb fund profits, or so we think. And, because these funds are equity funds, you will pay lower capital gains taxes, at 15% (short term, less than 1 year of holding) or 10% (more than 1 year of holding). This is better than a corresponding liquid fund, where the tax can go up as much as 43% since short term non-equity capital gains are just added to your income.

The Current Situation: Arb Funds have been getting a lot of money

Arb funds have seen their AUM go up by over Rs 20,000 cr. since March. March was crazy – arb funds saw exits of some Rs. 33,000 cr. in AUM, possibly because of the major disaster in the equity and debt markets after the Covid Impact became clear.

Arb Inflows

With this kind of inflow, how big are Arb Funds?

The Biggest Player in the Futures Market

The NSE Single Stock Futures market is the among the biggest in the world, and now, Arbitrage funds now hold more than 50% of the open interest in total. This has slowly increased in the last year, and for the last few months it’s been above 50%.

The NSE Single Stock Futures market is the among the biggest in the world, and now, Arbitrage funds now hold more than 50% of the open interest in total. Click To Tweet

Arbitrage Funds: You Don't Want to be the Elephant in the RoomAll figures, in Rs. Cr.

A note to remember: Arb funds are roughly 65% in equity, so the way to read this is: In Jun 2020, the total futures contracts for the near month has an open interest (number shares open in futures multiplied by the price) of 93,663 cr. Of that, the Arb funds will have 48,162 cr. or about 51% of the total open futures interest.

Why is this interesting?

It creates the biggest-player-problem. If you are the only elephant in the room, any move you make is noticed by every one else. An arbitrage player is supposed to take advantage of the difference in price when other players create a difference between stocks and futures. But if the arb player is the biggest in the room, what happens?

Everyone knows that the arb players have to rollover towards the end of the month. They know that the arb player will (in the end of June):

  • buy back the June future and
  • sell the July future

Typically such a rollover should be at a profit (the July future should be greater than the June future). But because arb funds are this big, a number of futures contracts show a “discount”, where the July Future quotes lower than the June one. At some point, the size will result in returns getting squished. Remember that already, one month returns for arb funds are now around 0.33% – which is an annualized 3.9%, which is fairly low.

Dividends have further skewed the game

Many companies give dividends in July. Reliance, for instance, is giving Rs. 6.5 as a dividend with the record date in July. On the record date, the stock will fall by Rs. 6.5 but the future, which already takes this into consideration, will not change.

If you look at the arbitrage right now, the July future (1738.7) quotes lower than the stock price (1741.6) by Rs. 3 or so – but if you consider the dividend, there is no “discount”.

However, many other stocks continue to be at a discount – HDFC Bank, ICICI Bank, SBI, TCS and Infosys, for instance, see their stocks quote higher than the price of a future. That’s not normal, considering there is unlikely to be a dividend for any of them in July. (The IT majors have already recorded a dividend, and the banks can’t pay because of an RBI diktat)

Arb ValuesNote: We haven’t included ITC because it announced a Rs. 10 dividend after market hours on Friday. That will only be adjusted in the price on Monday.

Arb funds are popular and can become even more so because of their tax advantage. However, we have to be careful that when they are the biggest players in the room, it leaves room for them to distort the market with their own actions, and for other players to take advantage.

You should now invest in Arb funds only when the skew is in your favour – that is, when the futures market is trading reasonably above current stock prices. Otherwise anyone entering now will effectively be paying higher prices for the stocks and a lower price for the futures.