What is an arbitrage fund
An arbitrage fund is an equity-taxed mutual fund that behaves more like a low-risk short-term instrument. Its niche is a mix of the two — which is exactly what makes it useful in some situations.
How it works
Arbitrage funds profit from small price differences between the cash market (where you buy the stock) and the futures market (where you sell a contract for the same stock at a later date). When the futures price is higher than the cash price, the fund buys the stock and simultaneously sells a matching futures contract. On expiry, the two converge and the fund pockets the spread.
Because the buy and sell are locked in at the same instant, the fund does not carry directional market risk. What it carries is spread risk — the spread might be small, negative, or missing altogether during certain market regimes.
Why the tax treatment matters
SEBI classifies arbitrage funds as equity for tax purposes, because they invest at least 65% in equity and equity derivatives. That means:
- Long-term (over 12 months): LTCG at 12.5% above ₹1,25,000 per year.
- Short-term (under 12 months): STCG at 20%.
Compare this to a liquid or ultra-short debt fund, which after the April 2023 tax change is taxed at slab. For someone in the 30% slab, a 6% arbitrage fund can beat a 7% liquid fund post-tax over similar horizons.
Where it typically fits
Arbitrage funds are commonly considered as a parking place for money with a horizon of a few months to about a year, particularly for investors in higher slabs. They are not a substitute for a savings account (redemption takes a day or two) and they are not an equity growth allocation.
What can go wrong
Returns compress in low-volatility markets. When spreads narrow, arbitrage funds can under-deliver on the return an investor was expecting. They are low-risk, not zero-risk.