Performance of Arbitrage Mutual Funds: Risk, Fund Size and Market Sentiments – Evidence from India

We examine the theory of decreasing returns to scale by assessing the impact of fund size on the performance of arbitrage mutual funds in India. Fund manager of arbitrage funds with large fund size tend to hold cash equivalents due to inadequate arbitrage opportunities, resulting in underperformance. The study formulates four equally weighted portfolios of selected arbitrage mutual funds on the basis of fund size and applies market model and Jensen’s differential return model (1968) to examine the differential performance of portfolios. We apply Bhardwaj & Brooks dual beta model (1993) to assess performance of arbitrage fund portfolios across different market sentiments specifically during bull and bear markets. We further apply Fama-French three factor (1993) and five factor (2015) models and Carhart four factor (1997) models for robustness checks. We find no significant difference between arbitrage fund returns and risk-free returns as well as the portfolio returns with different fund sizes. The small sized arbitrage mutual funds are more exposed to systematic risk than large sized funds in bearish market.