A regular client calls you, concerned that their equity savings scheme is lagging during a market rally, while noticing that the same fund has been generating stable returns during periods of high volatility. They ask if the fund manager is simply trading stocks or doing something more complex with options. As a distributor, you recognize that the manager is likely utilizing arbitrage, a strategy that seeks to exploit price discrepancies between the cash market and the derivatives segment to generate risk-adjusted returns without taking a directional view on the market.
Arbitrage using options essentially involves simultaneously buying or selling an underlying asset and its corresponding derivative to lock in a risk-free profit from the price difference. In the context of an equity savings scheme, the fund manager might observe that an underlying stock is trading at a lower price in the spot market compared to its synthetic value via options. By purchasing the stock and selling a call option, the manager captures the premium, effectively neutralising price fluctuations.
This is not gambling; it is a calculated mathematical play where the cost of carry and the time value of the option are key variables in the profit equation.
For an HNI client considering a move from a traditional liquid fund into an SIF investment strategy, it is vital to explain that these strategies are not intended to outperform a bull market index. Instead, their purpose is to provide a hedge against volatility, making them suitable for investors who have a lower risk appetite but still seek participation in the equity market.
You must highlight that while the risk is low compared to pure equity, these strategies are sensitive to changes in interest rates and market liquidity, which can shrink the arbitrage spread over time.
When recommending such funds, always verify the client’s understanding of the underlying risks. Even if the strategy is conservative, the use of derivatives requires that the client meets the necessary profile assessments. Failing to explain how arbitrage functions can lead to disappointment when the fund underperforms during a sharp, unidirectional market surge. By positioning these funds as volatility-management tools rather than alpha-generation vehicles, you ensure that expectations remain aligned with the fund’s mandate, thereby protecting your professional credibility and your client’s long-term interests.
Nuance
Check Your Understanding
An equity savings scheme manager observes that a stock is trading at ₹500 in the spot market, while a call option with a strike price of ₹500 is trading at a premium of ₹15, with the futures contract at ₹510. Which action constitutes a basic cash-and-carry arbitrage position?
Why might an investor choose an arbitrage-oriented mutual fund scheme over a pure-equity growth fund?
This is a companion read for Section 16.10 — Analysis of options from the perspectives of buyer and seller from Pass Certification Examination for Mutual Fund - Specialized Investment Fund Distributors by Akhilesh Gururani, available on Amazon Kindle.
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