The Securities and Exchange Board of India (Sebi) had eased rules for arbitrage funds in a bid to boost participation from the ₹3 trillion mutual fund category in the CAS. Under the change, arbitrage funds can take up to 1 per cent unhedged exposure, according to people familiar with the matter. 

Sebi communicated the change to mutual funds through the Association of Mutual Funds in India (Amfi) in the first week of September, seeking to address a key hurdle that had discouraged arbitrage funds from actively participating in the CAS.

Arbitrage funds are required to simultaneously take offsetting positions in the cash and futures markets to maintain the mandated net-zero equity exposure. Participation in the CAS, however, can leave a fund with an unhedged position if the cash-market order is not fully executed. 

“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, who asked not to be identified. 

Emails sent to Sebi and Amfi in this connection remained unanswered until press time. 

The 1 per cent leeway was intended to address that execution risk. But fund managers say the provision comes with its own risks and requires changes to internal processes before schemes can utilise the option. 

One concern is the potential impact on returns in a category where performance differences are measured in just a few basis points. Under Sebi rules, any unhedged position has to be closed in the next trading session, which could force a scheme to sell at a loss if the market moves against it. 

Such a loss can be material for an arbitrage scheme because the returns of the funds in the category are often separated by only a few basis points, the manager said. He also noted that most inflows go to the top few best-performing funds. 

Fund houses also face operational hurdles. Their risk-management systems typically have protocols to identify and flag trades that breach scheme mandates or otherwise deviate from prescribed limits. Incorporating the new flexibility would require those systems and controls to be modified. 

“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. 

Before using the provision, fund houses would also need to incorporate the 1 per cent leeway into their scheme documents through an addendum. So far, none of the 10 largest arbitrage funds has done so, according to people familiar with the matter.

The muted response in the first 15 days suggests fund houses are still assessing whether the additional flexibility in the CAS outweighs the investment, operational and risk-management costs of adopting it.