The new Closing Auction Session rules in place by SEBI have created short-term execution issues for arbitrage funds as well. They recommend spreading investments out over multiple dates instead of the entire amount being deployed at once.
The recent changes to the CAS rules introduced by the Securities and Exchange Board of India (SEBI) have brought a new execution challenge for arbitrage funds. While this change does not in principle change the strategy for arbitrage investing, investors will have to re-evaluate how much and when they put in fresh money to invest.
Harsh Kumar, Managing Partner and Co-Founder of Zvest Financial Services, suggested a staggered investment approach for investors looking to put new or additional money into arbitrage funds.
How has CAS changed Arbitrage fund trading?
The new CAS system was introduced for stocks with derivative contracts starting from August 3. In this new system, the cash market enters an auction session between 3:15 pm and 3:35 pm, and equity derivatives continue until 3:40 pm.
From the cash point of view, this creates a timing mismatch between the cash and futures markets.
Arbitrage funds usually try to take advantage of the price difference between the cash and futures markets. A fund manager generally buys a stock in the cash market and then sells the corresponding futures contract.
Before CAS, both segments were available for simultaneous trading. The new timing structure can make it more difficult for fund managers to execute both sides of the trade at the same time, thereby adding an element of execution risk.
As Kumar told NDTV Profit, during the auction window, investors may not have access to the corresponding derivative hedge when they are performing a cash-market transaction.
Why Should Investors Not Invest The Entire Amount At Once?
In view of this, Kumar said, investors don’t have to abandon arbitrage funds because of CAS changes. They could instead change their investment strategies, especially when investing fresh capital.
Kumar suggested not putting the entire amount into an arbitrage fund on the same day for investors who come into the category or who invest in incremental investments.
The reason is simple: If market conditions or execution challenges affect arbitrage opportunities on a particular day, investing the entire amount at that point could expose the investor to that day's market and execution conditions.
Spread Investments Across Three Or Four Dates
For investment purposes, Kumar suggested that investors invest on three or four dates in a month rather than the entire amount at once.
This staggered approach can help distribute the timing risk associated with entering the market on one day. If arbitrage spreads or market conditions are less favourable on one investment date, later instalments can be deployed under different market conditions.
It is particularly relevant for investment in big lump-sum funds or large amounts of already existing arbitrage funds.
CAS Provides an Execution Challenge, Not A Reason To Panic
The important takeaway is that the CAS changes have brought in an additional execution consideration for arbitrage fund managers, instead of making arbitrage funds intrinsically unsuitable for investors.
The cash-futures timing mismatch means fund managers need to be more careful in managing their trades, especially around the close date. Investors, though, could also shift their timing of new investments to reduce the risk of one day’s trading.
Instead of investing all the money in one go, spreading the money out over a number of dates can be a more measured approach in our current market.
However, investors should also consider their investment horizon, risk tolerance, and overall asset allocation before deciding whether arbitrage funds are appropriate for them.
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