Experts advise caution as CAS fuels arbitrage fund NAV volatility

Synopsis

Arbitrage fund net asset values saw a significant daily surge after the NSE introduced a closing auction session. Fund managers noted these movements were valuation effects and likely temporary. The new system introduces execution and hedging challenges for arbitrage strategies. Investors are advised against short-term trading and encouraged to extend holding periods. The market is expected to stabilize as participants adjust to the new mechanism.

Mumbai: Arbitrage fund investors were surprised Monday to see the net asset values (NAV) of their portfolios surge an average 0.46% in a single day, translating into an annualised yield of 167%. What explains such drastic movements in an asset class that barely yields 7% a year or about 0.02% a day? Well, this happened on the first day after the introduction of the closing auction session (CAS) for F&O stocks by the National Stock Exchange (NSE).

Fund managers said teething troubles with the new auction system will cause skewed NAVs. "For arbitrage funds, the CAS does introduce some execution and hedging considerations," said Kaivalya Nadkarni, fund manager, DSP Mutual Fund.

Agencies

Teething Trouble Incidents like a rise in arbitrage fund NAVs expected to happen until new system stabilises

Arbitrage strategies typically involve taking offsetting positions in the cash and derivatives markets simultaneously. "While the cash market for securities with available derivatives halts at 3:15 pm, the equity derivatives market continues to trade until 3:40 pm. This makes it more challenging to establish and hedge positions simultaneously," said Nadkarni.

Read more: Closing auction keeps traders on edge as divergence persists

Fund managers warn investors against trading in arbitrage funds with an eye on capturing risk free gains.

"Short-term NAV movements should not be viewed in isolation. The observed gain is largely a valuation effect and may reverse any time as cash and futures prices normalise," said a Kotak mutual fund note. Nadkarni said CAS participation accounted for only 2.2% of total daily turnover on the NSE and 0.7% on the Bombay Stock Exchange (BSE), leaving considerable scope for participation to build over time.

Fund managers point out more than half of Monday's gains have been erased from Tuesday's trading session and slowly, as volumes increase and players get adjusted, the system will stabilise.

This, however, will also not lead to increase in returns for long term investors. "Arbitrage spreads are locked and returns will be fully realised on expiry day. However, in between, one will see a lot of fluctuations on a day-to-day basis. With these new rules, volatility will go up, at least in the initial days," said Bhavesh Jain, president & co-head, factor investing, Edelweiss MF. To ride out this volatility, Jain said investors should increase their holding period in arbitrage funds from three months to at least six months until the closing-price mechanism settles.

Distributors, meanwhile, believe given the current volatility, investors should be extremely careful, stagger investments and have longer time frames.

"Stagger money over 8-10 trading sessions to help reduce any impact of temporary valuation fluctuations and increase your time frame to six months," said Anup Bhaiya, CEO, Money Honey financial services, a Mumbai-based distributor.