Arbitrage Funds in India: Balancing Stability and Tax Efficiency

What Are Arbitrage Funds?

An arbitrage fund is an equity-oriented hybrid mutual fund that earns returns by exploiting price differences in the cash (spot) and derivatives (futures) markets.

For instance, if a stock trades at ₹100 in the cash market and ₹105 in the futures market, the fund manager buys it in the cash market and simultaneously sells it in the futures market  locking in a ₹5 profit per share.

When such opportunities are limited, the fund invests in short-term debt or money market instruments, ensuring liquidity and stability. Because the trades are executed simultaneously, the risk of market direction is largely eliminated.

How Arbitrage Funds Work

Arbitrage funds function by identifying and executing these short-lived price differentials. The fund manager constantly monitors both markets and conducts multiple buy-sell trades daily to capture small profits that add up over time.

When the spread between spot and futures prices narrows, the fund temporarily moves part of its allocation into debt instruments. This flexibility allows the scheme to remain relatively stable  ideal for conservative investors seeking better post-tax returns than traditional savings options.

Arbitrage Funds Returns: What to Expect

Arbitrage funds returns tend to be consistent but modest, reflecting their low-risk nature. As of recent data, leading schemes in India have delivered the following indicative 1-year, 3-year, and 5-year returns (annualised):

(Data shown above is for informational purposes only and not investment advice.)

These returns indicate how arbitrage mutual funds can outperform traditional short-term investments like savings accounts or fixed deposits, especially after factoring in tax efficiency.

Arbitrage Fund Taxation

One of the key advantages of these funds lies in their tax treatment. Despite their conservative structure, they are taxed as equity funds, offering better post-tax outcomes than most fixed-income options.

• Short-Term Capital Gains (STCG): If units are sold within 1 year, gains are taxed at 20%.

• Long-Term Capital Gains (LTCG): If units are sold after 1 year, gains up to ₹1.25 lakh per financial year are tax-free. Gains beyond that are taxed at 12.5% (without indexation).

This structure makes arbitrage fund taxation particularly attractive for investors in higher income brackets who wish to park funds efficiently for short-term goals.

The Role of Arbitrage Funds in a Portfolio

Arbitrage funds are best suited for investors with short-term goals of 2–3 years, such as building an emergency fund, preparing for an upcoming expense, or temporarily parking surplus money.

They offer:

• Tax-efficient growth compared to traditional deposits.

• Liquidity with minimal exposure to market risk.

• Capital stability through disciplined, market-neutral strategies.

While they don’t deliver aggressive growth, they provide consistent, steady returns that keep your money productively invested  helping investors stay disciplined during volatile market periods.

In Summary

For investors seeking stability, liquidity, and efficiency, arbitrage funds serve as a reliable short-term investment option. They may not outperform equities, but they play a valuable role in preserving capital, earning steady returns, and maintaining financial discipline through market cycles.