However, fund managers said the movement was largely due to changes in the way stock closing prices are determined and should not be interpreted as a sudden jump in arbitrage opportunities.
What has changed in the closing price mechanism?
Earlier, stock closing prices on exchanges were calculated using the weighted average price of trades executed during the last 30 minutes of market hours.
Under the new mechanism, exchanges have introduced a dedicated closing auction session between 3:15 pm and 3:30 pm/3:35 pm, where buy and sell orders are matched to arrive at a single closing price.
The mechanism has initially been introduced for stocks in the futures and options (F&O) segment.
Since mutual fund NAVs are calculated based on the closing prices of securities held by schemes, any change in closing prices can impact the daily NAV movement of funds.
Why did arbitrage fund NAVs rise sharply?
Arbitrage funds typically generate returns by simultaneously buying shares in the cash market and selling futures contracts of the same stock. The difference between the two prices, known as the arbitrage spread, is the primary source of returns.
According to Bhavesh Jain, President and Co-head, Factor Investing at Edelweiss Mutual Fund, the NAV calculation method for mutual funds has not changed. The change is only in how the underlying closing prices are arrived at.
Explaining the movement seen after the rollout, Jain said arbitrage funds held long positions in equities and short positions in futures. On August 3, the closing price of the cash market moved higher compared with the pre-auction price, while futures did not move in the same proportion.
As a result, equity holdings were marked at the higher closing price, leading to a sharp increase in NAVs for arbitrage funds.
He described the move as a “marking anomaly” rather than an actual change in the returns generated by the arbitrage strategy.
Was the one-day gain a real return?
Not necessarily.
Arbitrage fund returns are ultimately linked to the spread captured between cash and futures markets. The daily NAV can fluctuate because the two legs of the trade are marked differently during the month.
Jain said the sharp rise seen on August 3 was followed by negative NAV movements in subsequent sessions as the impact reversed.
He added that over a slightly longer period, the returns were closer to the normal range expected from arbitrage funds.
Should existing arbitrage fund investors worry?
For existing investors, fund managers said there is no need to react to the short-term NAV volatility.
The underlying arbitrage positions and the strategy remain unchanged. Investors who remain invested through the expiry cycle are expected to receive the returns based on the arbitrage spreads captured by the fund.
What should fresh investors do?
Investors looking to enter arbitrage funds during this transition period may avoid making a large lump sum investment on a single day, according to Jain.
He suggested staggering investments, as short-term NAV movements could remain volatile while market participants adjust to the new closing auction mechanism.
He also suggested investors consider a longer investment horizon until the system stabilises.
Impact on index funds and ETFs
The new closing mechanism could have a longer-term impact on passive funds such as index funds and exchange-traded funds (ETFs).
Index funds attempt to replicate the performance of an underlying index. Any difference between the fund’s execution price and the index closing price contributes to tracking error.
Jain said a single closing price through the auction mechanism could help reduce such differences over time.
However, he highlighted that adequate liquidity in the closing auction session would be critical, especially during index rebalancing days when funds need to execute large trades.
