Arbitrage funds shining, but should you follow the herd?

The asset under management of equity funds hit a record high of Rs 4 lakh crore at the end of June, with the month seeing an addition of 4.9 per cent or Rs 18,711 crore additional investments.

Jul 17, 2015 05:07 IST India Infoline News Service

The inflow of investments into the equity fund basket has been heavy and brisk over the past few months, thanks mainly to the bullish undertone of the domestic equity market, improving fundamentals of the economy and a general depression in several other asset classes like gold, real estate and even some of the debt products.

The asset under management of equity funds hit a record high of Rs 4 lakh crore at the end of June, with the month seeing an addition of 4.9 per cent or Rs 18,711 crore additional investments.

Lakhs of investors have come into equity mutual funds in the past one year with the total number of mutual fund folios for equity-oriented schemes hitting 3.22 crore mark.

Even overseas equity funds focussed on the Indian market witnessed an inflow of over $9.5 billion from investors the world over in the first six months of the year, even as China saw a hefty outflow of $17 billion in the same period.

A closer look at the asset growth patterns suggest a large chunk of this additional money is actually coming into the arbitrage funds, whose share in the total equity assets under management has gone up from 1 per cent two years back to about 7 per cent today.

Arbitrage funds generate returns by leveraging the price differential in the cash and derivatives markets. For instance, you can buy 1,000 shares of X company in the cash market when it is trading at Rs 990 a share and sell an equivalent number of shares in the futures market, at say Rs 1,000 a share, to earn a spread of Rs 10 per share.

The futures market has been offering many such opportunities thanks to the bullish undertone of the market and the arbitrage funds have cashed in on it to generate annual returns of 8.5-9 per cent, which are higher compared with liquid funds or many other fixed income assets, thus becoming an instant draw for investors.

But thanks to the market’s tendency to follow a herd mentality, it may not be prudent to go whole hog into these funds at this stage. First of all, the medium to long-term outlook for the market is not very bullish at this stage, which might reduce such arbitrage opportunities in the futures market.

Secondly, some analysts point out that this segment has already seeing a huge concentration with arbitrage funds now accounting for half of the open interest of derivative stocks compared with less than 5 per cent two years ago. This will impact the returns of arbitrage funds.

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