Markets move every day, but not every investor wants to move with them. Many prefer their money to remain productive without being exposed to sharp ups and downs. This is especially true when the investment horizon is short, or when capital preservation matters more than chasing high returns. In such situations, arbitrage funds quietly fit in. They are designed to benefit from small pricing gaps in the market, aiming to deliver steady, low-risk returns while still enjoying the tax treatment of equity mutual funds.
This article covers what arbitrage funds are, how they work, their benefits and limitations, and the tax rules investors should understand before investing.
What are Arbitrage Funds?
Arbitrage funds are a category of equity-oriented mutual funds that aim to profit from price differences in the same security across different markets. In India, this typically means exploiting the difference between the cash market and the futures market for a stock.
Instead of predicting whether markets will rise or fall, these funds focus on locking in small, relatively predictable spreads. Since both the buy and sell transactions happen almost simultaneously, the strategy reduces exposure to market direction. This is what gives arbitrage funds their relatively stable return profile. Although they are classified as equity funds for taxation, their behaviour is closer to low-risk strategies than traditional equity investing.
How Arbitrage Funds Actually Work
To understand the mechanism, it helps to look at a simple example from Indian equity markets:
Suppose a stock is trading at ₹1,000 in the cash market but at ₹1,010 in the futures market for the next month. An arbitrage fund will buy the stock in the cash market and simultaneously sell it in the futures market. When the futures contract expires, both prices converge. The difference, after costs, becomes the fund’s return.
This process does not rely on market direction. Whether the Nifty rises or falls is largely irrelevant. What matters is the existence of a price gap at the time of execution. Because of this structure, arbitrage funds tend to show lower volatility than pure equity funds.
Why Do Arbitrage Opportunities Exist?
In an efficient market, price differences should not exist for long. However, real markets are driven by demand, supply, and liquidity. Futures prices often reflect expectations, leverage, and hedging demand, while cash prices reflect immediate buying and selling pressure.
In India, derivatives markets are highly active, especially during periods of volatility. This creates short-lived inefficiencies. Arbitrage funds are designed to capture these inefficiencies systematically. When markets are volatile, spreads tend to widen. When markets are calm, spreads shrink. This is why returns from arbitrage funds vary across market cycles, even though the risk profile remains relatively stable.
Setting the Right Expectations
Expected Returns
One of the most common mistakes investors make is expecting arbitrage funds to deliver equity-like returns. That is not their purpose. Historically, arbitrage funds in India have delivered returns slightly higher than liquid funds and savings accounts, especially during volatile periods. However, in calm and trending markets, returns can moderate.
This does not mean the strategy is failing. It simply reflects the availability of arbitrage opportunities. A mutual fund advisor often plays an important role here by aligning return expectations with the fund’s actual objective.
Risk Profile
These funds are often described as low risk, but not risk-free. They carry limited market risk because buy and sell positions are matched. However, they are exposed to execution risk, liquidity risk, and spread risk. If spreads narrow sharply or transaction costs rise, returns can be impacted.
Unlike fixed deposits, returns are not guaranteed. Still, compared to equity funds, drawdowns tend to be shallow. This makes arbitrage funds suitable for conservative investors who still want market-linked instruments.
Tax Rules for Arbitrage Funds in India
One of the biggest reasons investors consider these funds is taxation. In India, arbitrage funds are treated as equity mutual funds because they maintain more than 65 percent equity exposure, even though positions are hedged.
- Short-term capital gains, for holdings below one year, are taxed at 20 percent
- Long-term capital gains, for holdings above one year, are taxed at 12.5 percent beyond the exemption limit
This tax treatment often makes arbitrage funds more efficient than debt funds for short-term investments, especially for investors in higher tax brackets.
Benefits and the Role of Arbitrage Funds in a Portfolio
These funds are not meant to replace equity funds or long-term investments.
- They are commonly used to park surplus cash when investors are unsure about market direction. Instead of leaving money idle in savings accounts, arbitrage funds allow capital to remain invested with relatively low volatility. This helps improve return efficiency without taking meaningful directional risk or tax liability.
- Arbitrage funds are also useful during asset allocation shifts. When investors rebalance from equity to debt or wait to redeploy money into equity, these funds act as a temporary holding option. They help avoid timing pressure while maintaining tax efficiency.
- For short to medium-term holdings, due to their equity taxation despite low volatility, arbitrage funds offer better post-tax outcomes compared to debt or liquid funds, especially for investors in higher tax brackets.
- Because arbitrage funds typically experience shallow drawdowns, they also help reduce overall portfolio volatility. This makes them suitable as a stabilising allocation alongside more volatile assets.
A mutual fund consultant can help determine whether this role fits an investor’s broader portfolio structure and time horizon.
Who Should and Should Not Invest
- These funds are suitable for investors with short-term goals, conservative risk profiles, or temporary cash allocations.
- Those seeking stability and tax efficiency are more likely to benefit.
- They are less suitable for long-term wealth creation or aggressive growth strategies.
- Investors expecting high returns may be disappointed.
Things to Evaluate Before Investing
- Expense ratio – Arbitrage strategies operate on narrow return spreads, so lower costs directly improve net returns.
- Holding period – The investment horizon should align with equity tax rules to make arbitrage funds worthwhile.
- Market conditions – Returns tend to be better during volatile markets and more modest during calm periods.
- Return expectations – These funds aim for stability and tax efficiency, not high or long-term growth.
- Portfolio role – These funds work best for short-term surplus parking or temporary allocations, not as core investments.
- Tax bracket – Investors in higher tax slabs benefit more from equity-style taxation.
- Professional guidance – A mutual fund advisor can conduct a more thorough due diligence, like ensuring that the underlying holdings of an arbitrage fund are liquid enough to execute quick trades. They can also help confirm whether this category actually fits the investor’s broader financial plan, and help avoid mismatches between expectations and outcomes.
Arbitrage Funds vs Liquid and Debt Funds
Investors often compare arbitrage funds with liquid funds and ultra-short-term debt funds, since all three are commonly used for short-term money management. However, their behaviour, return drivers, and post-tax outcomes differ in important ways.
Return profile and volatility
The Underlying Holdings, Risk, and Return
- Liquid and ultra-short-term debt funds typically invest in treasury bills, commercial papers, and short-maturity bonds.
- Their returns are relatively stable and closely track short-term interest rates. Historically, liquid funds in India have delivered returns broadly in the range of savings accounts to slightly higher, depending on the interest rate cycle.
- Arbitrage funds, on the other hand, do not depend on interest rates. Their returns depend on the availability of price spreads between the cash and futures markets.
- During volatile market phases, these spreads tend to widen, allowing arbitrage funds to generate higher returns. In calmer markets, spreads shrink, and returns moderate. This leads to slightly higher variability compared to liquid funds, though still far lower than equity funds.
- Liquid funds carry minimal market risk but are exposed to credit risk, although this is tightly regulated.
- These funds largely avoid credit risk but are exposed to execution and spread risk. In rare periods of extremely low volatility, arbitrage returns can fall below expectations.
Taxation Impact: Where the Difference Becomes Meaningful
- Liquid and debt funds are taxed as fixed income instruments. Both short-term and long-term capital gains are taxed according to the applicable slab rate. For investors in the higher tax brackets, this can significantly reduce post-tax returns.
- Arbitrage funds on the other hand are treated as equity funds for tax purposes.
- For holding periods of more than one year, this difference alone can result in a noticeably higher post-tax outcome, even if pre-tax returns are similar. This is why arbitrage funds are often preferred by higher-income investors for short-term allocations.
Difference in Roles Within a Short-Term Portfolio
- Liquid funds are commonly used for emergency reserves and very short-term cash needs.
- Arbitrage funds are often used for short-term surplus parking beyond a few months.
- Debt funds suit investors willing to accept interest rate risk for slightly higher yields.
The choice depends on the investment horizon, tax bracket, and tolerance for small fluctuations in returns. For investors in higher tax slabs, a mutual fund advisor often evaluates arbitrage funds as a tax-efficient alternative once liquidity needs are clearly defined.
Final Thoughts
Arbitrage funds occupy a unique space in the Indian mutual fund landscape. They are neither traditional equity funds nor pure debt alternatives. Their strength lies in stability, discipline, and tax efficiency, not high returns.
Used appropriately, they can serve as a valuable tool for managing short-term money and navigating volatile markets. Like most financial instruments, their effectiveness depends on clarity of purpose and correct placement within a portfolio.
FAQs About Arbitrage Funds
Q: Are arbitrage funds guaranteed to deliver returns?
A: No, arbitrage fund returns are not guaranteed. Returns depend on market conditions and available arbitrage spreads, so they’re not completely risk-free like a fixed deposit, but historically provide returns similar to short-term debt.
Q: What returns can I expect from arbitrage funds?
A: Arbitrage funds aim for low-risk, market-neutral returns, typically generating returns in the 6-7.5% annualized range. Returns vary with market conditions, fund spreads, and expense ratios, so past performance is not a guarantee of future outcomes. Investors should maintain realistic expectations and consult a mutual fund advisor for guidance aligned with their portfolio goals.
Q: Are arbitrage funds the same as liquid funds?
A: No, arbitrage funds and liquid funds serve similar short-term purposes but work differently. Liquid funds earn returns from interest on debt instruments and are taxed as debt. Arbitrage funds earn returns from market price spreads and are taxed as equity. This difference in taxation can significantly affect post-tax returns.
Q: How long should one stay invested in arbitrage funds?
A: Arbitrage funds are best suited for short- to medium-term holding periods. A holding period of about 18 months often makes sense, especially to benefit from equity taxation. Very short holding periods may reduce the tax advantage.
Q: Do arbitrage funds perform well in falling markets?
A: Arbitrage funds are not dependent on rising or falling markets. Since they use matched buy and sell positions, gains or losses from one leg are typically offset by the other. This structure means that whether markets rise or fall, the fund can still capture the price difference, making returns relatively stable. However, extreme market conditions such as sudden sharp declines, unusual volatility, or illiquid trading periods, can affect the spreads between cash and futures prices, which may temporarily reduce returns. Investors should therefore understand that while arbitrage funds are low-risk, they are not entirely immune to exceptional market events.
Q: Are arbitrage funds suitable for first-time investors?
A: Yes, arbitrage funds can be suitable for first-time investors who want low volatility and simple exposure. However, they should be viewed as a short-term allocation tool rather than a long-term wealth creation product. A mutual fund advisor can help clarify expectations.
Disclaimer: This article is intended solely for informational and educational purposes. It does not constitute investment advice. The tax rates, return expectations, and other information mentioned are based on applicable laws and market conditions as of 22/12/2025 and are subject to change. Mutual fund investments are subject to market risks.
