Despite SEBI's regulatory relaxation allowing arbitrage mutual funds to temporarily carry unhedged positions of up to 1% of their assets under management (AUM), the industry has shown limited enthusiasm for adoption. According to Business Standard reports, none of the 10 largest arbitrage funds has incorporated the 1% leeway into their scheme documents through an addendum, even after the regulator communicated the change to mutual funds through the Association of Mutual Funds in India (Amfi) in the first week of September. The muted response in the first 15 days suggests fund houses are still assessing whether the additional flexibility in the closing auction session outweighs the investment, operational and risk-management costs of adopting the new provision.
Arbitrage funds face significant operational challenges with the new 1% leeway provision, as reported by Business Standard. Fund managers express concerns about execution risk, noting that participation in the closing auction session can leave a fund with an unhedged position if cash-market orders are not fully executed due to lower liquidity or price fluctuations. "If the cash-market trade does not fully go through in the CAS owing to lower liquidity or price fluctuations, the scheme would end with an open position as the trade in the futures market would have gone through," said an arbitrage fund manager. Under SEBI rules, any unhedged position must be closed in the next trading session, which could force a scheme to sell at a loss if the market moves against it. The fund manager highlighted that "an arbitrage fund may earn around 1.5-2 basis points in a day. If you have a 1% unhedged position and that position moves against you by 2 per cent, you have effectively lost one day's return."
Mutual funds are increasingly participating in India's new closing auction session (CAS), but primarily for trades too small to materially impact their net asset value (NAV). As reported by Mint, fund managers are avoiding substantial trades due to concerns about sharp price swings that can occur within the 15-minute auction window. The system's early months have demonstrated significant volatility, with the Nifty jumping nearly 200 points in closing minutes on the first day, while the Sensex barely moved. On 3 September, the Sensex plunged about 2,100 points within minutes during the auction on a weekly expiry day, before recovering most of the fall to close 417 points lower. A mutual fund executive explained that "Mutual funds are avoiding CAS for trades that are substantial in value and volume, and hence important to the fund house. Trades that are not very important and do not impact P&L are being sent to CAS."
Fund houses face substantial operational hurdles in implementing the new flexibility, as detailed by Business Standard. Their risk-management systems typically have protocols to identify and flag trades that breach scheme mandates or deviate from prescribed limits, requiring modifications to incorporate the new flexibility. "The challenge is on the internal side -- procedures, rules and risk-management guidelines all have to be changed. The systems have to be changed to ensure that such orders can be safely entered and monitored. It is still a work in progress," said the chief executive officer of a large fund house. The operational complexity extends beyond systems, as fund houses would also need to incorporate the 1% leeway into their scheme documents through an addendum before using the provision. Value Research's Dhirendra Kumar noted that "Picture the dealer. Work an order through the day and he can point to VWAP. Put the same size into a 15-minute window and he has no cover. A print 3% off the market is his to explain to the trustees."
Arbitrage mutual funds held a combined ₹3 trillion ($31 billion) in assets at the end of August, making them a significant source of market liquidity. The new 1% allowance lets funds carry temporary mismatches instead of staying fully hedged at all times, addressing the challenge that several institutional investors have largely stayed away, citing thin volumes that aggravate price moves and make it harder to set stable end-of-day prices. This regulatory change aims to bring key institutional players into the auction process that has struggled since its launch on 3 August. Despite SEBI's efforts to increase participation, mutual fund participation in CAS had risen to nearly 25% of total volumes by mid-August, from about 5% when the framework was introduced, according to Mint.
