How can arbitrage funds adapt to changing volatility?

Arbitrage funds are relatively low-risk investment options that aim to generate returns by capitalising on the price difference between the same asset or security in two different markets or segments – such as spot and futures.

This article discusses how arbitrage fund categorised as hybrid funds can adapt to change in market using various strategies.

• Table of contents

1. Understanding volatility in the market
2. Challenges faced by arbitrage funds in changing volatility
3. Strategies to adapt to changing volatility
4. Understanding market neutral approach of arbitrage mutual funds
5. Explore arbitrage fund opportunities in market volatility
6. Factors to consider when exploring a market-neutral approach of arbitrage fund investment

Understanding volatility in the market

Volatility refers to the variation in the price of a stock over a given period. It represents how uncertain or risky the market is with respect to the movement of stock prices. High volatility suggests greater uncertainty and risk associated with the movement in stock prices.

Additionally, factors like increasing inflation, rising interest rates, fears of recession, and geopolitical tensions also contribute to market volatility. During periods of high volatility, the gap between cash and futures prices widens as market participants hedge their positions or carry out speculative trades.

While large price discrepancies provide potential opportunities for arbitrage trades, they also pose certain risks. There is a chance of potential losses for arbitrage funds if the prices move against their positions before they can close out trades. Also, sustained high volatility can narrow down the number of opportunities available as more participants try to benefit from the wide divergences. This creates challenges for generating a consistent return potential.

Challenges faced by arbitrage funds in changing volatility

• Reduced trading opportunities: During volatile periods, arbitrage opportunities can dry up if many participants try to exploit the wide price gaps. This shrinks the trading bandwidth.
• Widened trading range: Higher volatility may increase the risk of unfavourable market movements against open arbitrage positions.
• Higher capital requirement: Volatile markets may require arbitrage funds to deploy larger capital to take advantage of opportunities. This ties up more funds.
• Liquidity risk: In a sell-off, the ability to square off positions in a short time span is challenged due to reduced liquidity. This may potentially increase losses.
• Margin requirements increase: Leveraged positions needed by arbitrage trades become relatively riskier in turbulent times. Funds may have to reduce exposures if unable to meet higher margin costs.

Strategies to adapt to changing volatility

• Maintain adequate liquidity: Funds should keep sufficient cash reserves to easily cover margins and square off trades without facing liquidity issues. This also helps tap into opportunities quickly.
• Diversify strategies: In addition to traditional index and cash-futures arbitrage, funds can employ new strategies like stock pair trading, and intra-day trading.
• Mitigate risk through hedging: Hedging techniques like index futures, stock futures, and options can be used to insulate positions from unfavourable price movements.
• Deploy algorithmic tools: Technology tools like algorithmic trading based on volatility indicators help detect opportunities, control risks and enhance the efficiency of arbitrage execution.
• Trade shorter timeframes: Opportunistic short-term and intra-day trades that do not require large exposures are preferred over long-term trades that are risky.
• Manage leverage prudently: Leverage levels can be dynamically adjusted based on volatility forecasts rather than maintaining fixed leverage throughout.
• Maintain flexibility in trade sizes: The ability to experiment with low to high trade sizes based on risk-adjusted returns and volatility may allow optimum utilisation of opportunities.

Understanding market neutral approach of arbitrage mutual funds

Arbitrage funds are categorised under hybrid funds. The market-neutral approach of arbitrage mutual funds is used to earn potential returns while attempting to minimise sensitivity to broader market movements. Fund managers try to achieve a balance so that gains in some investments offset losses in others, resulting in a relatively stable return potential regardless of overall market trends. This market-neutral approach of arbitrage fund investment (of taking offsetting positions) potentially helps them take advantage of relative price movements while minimising exposure to overall market direction.

Explore arbitrage fund opportunities in market volatility

Periods of volatility can create better arbitrage opportunities because of increased price differentials and inefficiencies across markets. Here are a few arbitrage strategies:

Volatility arbitrage: Volatility arbitrage means trading options, futures, or other derivatives to potentially capitalise on discrepancies between implied volatility and the actual price movements of the underlying assets.

Price discrepancies between stock exchanges: In times of market volatility, fund managers seek to capitalise on price divergences between related securities or assets. They simultaneously buy undervalued assets and sell overvalued assets to generate return potential when prices revert to their fair values.

Merger and acquisition arbitrage: It involves trading securities of companies involved in mergers, acquisitions, or corporate restructuring activities. Fund managers simultaneously buy shares of the target company and short-sell shares of the acquirer (or vice versa) to potentially capture the spread between the current and the expected price.

Factors to consider when exploring a market-neutral approach of arbitrage fund investment

Here are some factors you must consider when exploring the market-neutral approach of arbitrage utual funds:

Types of strategies employed: Understand the specific market-neutral strategy employed by the fund, including convertible arbitrage, merger arbitrage, volatility arbitrage and so on.

Role of the fund in your portfolio: Assess why you want an arbitrage fund in your investment portfolio. Such a fund does not typically yield returns as high as a well-performing equity fund in the long run but can be used as a relatively low risk short-term investment tool. Determine the appropriate allocation size based on your investment strategy, risk appetite, and portfolio construction principles.

Liquidity and redemption terms: Consider the liquidity profile of the arbitrage fund, including the liquidity of underlying assets, redemption terms, and investor exit options.

Transparency and reporting: Seek transparency and disclosure from the arbitrage fund regarding portfolio holdings, trading activities, performance attribution, and risk exposures. Evaluate the quality and frequency of reporting, investor communications, and access to information to make informed investment decisions and monitor portfolio performance effectively.

Fees and expenses: Understand the fee structure of the arbitrage fund, including management fees, performance fees, and other expenses. Evaluate the impact of fees on net returns and consider whether the potential benefits of the market-neutral approach justify the cost incurred.

Conclusion

The above information shows how arbitrage funds adapt to changing volatility. Arbitrage funds can proactively adjust their trading strategies based on changing market volatility to manage risks and generate alpha. The approach involves liquidity management, risk hedging and leveraging technology. This can potentially help arbitrage funds deliver low-risk returns.

Individuals looking to invest in this type of fund may consider Bajaj Finserv Arbitrage Fund. The investment objective of the scheme is to seek to generate returns by investing in arbitrage opportunities in the cash and derivatives segments of the equity markets and by investing balance in debt and money market instruments. However, there is no assurance that the investment objective of the Scheme will be achieved.

FAQs

What risk management techniques are employed by arbitrage funds in volatile markets?

Arbitrage funds try to remain market neutral by balancing long and short positions that can potentially gain from price discrepancies, rather than taking on directional market risk. They closely monitor positions and use stop-losses to automatically exit trades if prices move too far in the unwanted direction in order to limit downside exposure.

Is there any risk associated with arbitrage funds?

While comparatively less risky than pure equity funds, arbitrage funds carry certain risks such as market risk, liquidity risk, counterparty risk, and management risk.

What is the market-neutral approach of arbitrage fund investment?

The market-neutral approach of arbitrage mutual funds is an investment strategy designed to generate return potential that is independent of overall market movements. They aim to achieve positive returns regardless of whether the broader market is rising, falling, or remaining relatively stable.

How can liquidity risks impact market-neutral strategies?

Low liquidity may delay or prevent the timely execution of arbitrage opportunities, impacting the arbitrage fund's ability to capture the price differences between markets and generate return potential. It can be challenging to execute trades at desired prices, leading to higher transaction costs, change in bid-ask spreads and potential price slippage.

What are the potential benefits of the market-neutral approach of arbitrage mutual funds?

The market-neutral approach can help arbitrage fund investors manage risk and generate reasonable returns across different market environments.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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