There seems to be a fair bit of confusion amongst investors on what’s happening in arbitrage funds. Let me explain the arbitrage space and how it works with MFs. Not sure if it is simple enough but have tried (1/n)

Mutual Funds do cash future arbitrage. Assume a stock to be at 100 in cash market and 101 in futures market at the start of the month. Mutual Funds will buy stock in cash market at 100 and sell futures at 101 thereby locking a 1 Re profit. (2/n)

Last Thursday which is the expiry, the cash and future prices merge (that’s how it works), so irrespective of whatever the cash price is, the fund still makes 1 Re. (3/n)

Lets say the price goes to 500, which means the fund will make 400 (500 – 100, current price minus the buying price) on the cash and loose 399 in the futures (101-500) making the net profit 1 Re. (4/n)

Normal market functions in a way where the futures are at a premium to cash (because of cost of carry), like above 100 in cash and 101 in futures. But there are instances where the futures can be at a discount, (5/n)

(a) Buying happening in cash market where as the overall sentiment is negative. This is the current case. Currently the futures are/were in discount because there was an MSCI rebalancing and hence cash buying had increased but there was shorting in the futures market. (6/n)

(b) If you are expecting some corporate action in a stock like say dividend, the future trades at negative because after dividend the stock price falls by that amount and hence futures is in negative. (7/n)

Last month Arbitrage returns were good, why?
So lets say MF did an arbitrage by buying the stock in cash at 100 and selling futures at 101 and the future went into discount and hence the futures become 99. MFs will actually square up their position (or make MTM profit). (8/n)

They bought stock at 100 in cash, which is still at 100 so no losses there, but future MF sold at 101 is now 99 and hence MF makes 2 Rs. Instead of 1 they were expecting. That’s what happened in the last months roll over. (9/n)

What’s the scene this month?
Right now futures is @ 99 & cash @ 100 & hence MF cant do arbitrage. 2 make money they have to sell cash@ 100 & buy futures @ 99. Buying futures @ 99 is okay but the fund can’t sell stock in cash @ 100 bcoz they don’t have stocks 2 give delivery(10/n)

So till the time market stays in backwardation (futures at a discount to cash), MFs will park this money in Liquid Funds, Over Night Funds or CBLO/TREPs (over night lending) and hence return may be low for this month as there is no opportunity. (11/n)

Volatility is good for Arbitrage funds but don’t invest in this space for less than 3 months. Over all as rates have fallen, Liquid/over night may also not generate higher returns and Arbitrage in that sense is better off in terms of post tax returns. (12/12) (End)