Kodak Mutual Fund has issued a warning on arbitrage spreads. At least 65% of their assets are invested by arbitrage funds in stocks than sell their futures generating a return from the spread between spot and futures prices. For the first time in a decade, the average arbitrage spreads of Kodak mutual funds have gone negative. A spread is a difference between the price of a stock and the price of the futures contract. Arbitrage funds are a category of mutual funds delivering returns from positive arbitrage spreads. A fall in the spread makes future return difficult. Arbitrage funds invest at least 65% of their assets in stocks then later sell their futures generating a return.
A small part of arbitrage funds is invested in debt and this will cushion returns. The Kotak MF note highlighted that the arbitrage industry has grown to a significant size of the total open interest. This is because their needs to be sufficient interest from foreign institutional investors. Sufficient interest also needed from high net worth individuals in stock futures. The arbitrage industry pegged at Rs. 60,000 crore is currently a large part of the arbitrage market. Structurally the market consists of entities like arbitrage funds foreign institutional investors, domestic institutional investors, and HNIs. The arbitrage industry is to a large part arbitrage funds and they do not buy futures to speculate.
What has happened to the mutual fund industry?
Compression in arbitrage spreads had previously hit the mutual fund industry at the end of March. This resulted in fund houses such as ICICI Prudential, AMC, and TATA mutual funds to halt inflows for a time. The CEO of Kotak Mutual Fund did not comment if they also take similar steps. Arbitrage funds typically give returns in line with short term interest rates such returns have been falling steadily. This steady fall is caused by successive rate cuts and liquidity easy measures by the RBI. In addition to the RBI measures, the arbitrage funds are also affected by overall sentiment in the market. The arbitrage funds capitalized on the spread between spot and futures prices. This spread can fall to zero or even to negative in times of extreme bearishness. Kotak mutual fund said on the positive side, that returns have been higher in the last couple of expiries due to higher volatility in the equity market. Thus, compression of spreads at the start of the month may not necessarily imply poor returns throughout the months.
