No whiplash, no windfall? Arbitrage funds face quiet markets

Recent data suggests a strong link between volatility and fund flows. For instance, in May 2025, India’s fear gauge—the India VIX—averaged a one year-high of 18.02, and arbitrage funds logged their highest monthly inflows in a year at ₹15,702 crore, according to Bloomberg and AMFI data.

In contrast, during September 2024, when volatility cooled to a 12-month low of 13.29 and the Nifty touched lifetime highs, arbitrage fund outflows of ₹3,532 crore were the highest in a year.

There may be short periods of low activity, like a sideways movement, also known as consolidation zone, ahead of key events, but once the event passes, things usually return to normal, explained market participants. While the recent dip in volatility may cause short-term impact on arbitrage fund returns, they stress it’s not likely to be significant or long-lasting.

That said, there’s another important factor to watch: interest rates. When rates fall, spreads in arbitrage positions tend to narrow, which can reduce potential returns to some extent, they added.

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Turning market swings into returns

Arbitrage funds make money in two primary ways: by capturing the price difference in cash and futures market and churning portfolio during intra-month volatility.

In the first instance, they make money by buying a stock in the cash market and simultaneously selling it in the futures market (or vice versa). The spread is the profit margin they earn from this price difference.

For example, if stock A trades at ₹1,000 in the cash market and ₹1,020 in the futures market, the spread is ₹20. The wider this spread, the higher the potential return.

When stop-losses get hit, traders exit futures—selling if they were long, or buying back if they were short, said Deepak Gupta, fund manager at Invesco Mutual Fund.

Going long means buying with the hope that prices will rise; going short means selling first, expecting prices to fall and buying later at a lower price.

This helps unwind existing arbitrage positions profitably or set up fresh ones, depending on the situation. During periods of heightened volatility, such activity picks up. But when both volatility and volumes fall, it affects arbitrage funds adversely, he said.

Gupta cautioned, “A dull market with low volatility and low cash/futures market volumes is the worst combination for arbitrage funds. There’s just not enough opportunity to churn the portfolio.”

However, a low-volatility market trending upwards can still be favourable for these funds, he added.

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The strategy of churning portfolio during intra-month volatility involves exiting positions where spreads have shrunk and entering new ones with wider spreads. Volatility helps by creating these shifting opportunities through active buying and selling in specific sectors or stocks.

Beneath the calm

Despite the Nifty’s seemingly quiet behaviour—up barely 1% in the month upto 17 July —fund managers argue that volatility still exists at the sector and stock level, offering scope for arbitrage strategies.

There’s still day-to-day activity in the market, though to be fair, the overall volume may have come down, said Sailesh Jain, fund manager of equities at Tata Mutual Fund.

“That said, we are now in earnings season, and with results starting to come in, volatility is expected to pick up, which will create ample opportunities for arbitrage funds.”

As evidence, the start of the earnings season has already triggered sharp post-result movements in IT stocks like TCS and HCL Tech. While the bluechip index may not reflect much, sector-specific volatility like knee-jerk reaction in Nifty IT creates enough churn for arbitrage funds to benefit.

These pockets of movement, even without broad market swings, are exactly what such arbitrage strategies thrive on.

Jain pointed out that one year returns of arbitrage funds, in general has been around 8% returns on average in 2024, as softening interest rates and narrower spreads begin to weigh in.

So, even if the Nifty 50 looks calm at first glance, there’s still plenty of movement beneath the surface—in individual stocks and sectors. This could continue to create opportunities for arbitrage funds, though they may need to be more selective and nimble in their positioning.

Also read: India’s biggest companies are underperforming FDs. Here’s why Reliance is different.