Have you ever noticed how the same fruit can cost differently in two markets on the same day? You might buy mangoes at ₹100 a kilo in one market, but just a few streets away, they’re selling for ₹120. Some traders spot this difference and quickly buy from the cheaper market to sell where prices are higher, —earning a small, risk-free profit. That’s what we call arbitrage.
Now imagine this concept applied to stocks instead of mangoes. But of course, financial markets are far more complex than fruit stalls—prices move in milliseconds, and the gaps between markets can be razor-thin. That’s where professional fund managers step in, using technology and strategy to capture these fleeting differences and convert them into consistent gains.
When fund managers identify similar price gaps across markets, they execute offsetting trades to lock in small, risk-free profits. This strategy forms the foundation of arbitrage mutual funds. Let’s explore how they work, what makes them useful, and whether they deserve a spot in your portfolio.
What is an Arbitrage Fund?
An arbitrage fund is a type of equity-oriented mutual fund that aims to profit from price differences of the same security across different markets—typically between the cash (spot) market, the futures market, or even different stock exchanges where the same stock might momentarily trade at different prices.
According to SEBI’s regulations, at least 65% of the fund’s total assets must be invested in equities, while the remaining can be allocated to short-term debt or money market instruments to ensure liquidity and stability.
In essence, arbitrage funds behave like equity funds structurally, but like debt funds when it comes to risk. They serve investors who want the tax benefits of equity but prefer lower volatility, making them an interesting middle ground between debt and equity investing.
To understand why they can be useful, let’s look at how this entire mechanism works in real market conditions.
How do Arbitrage Funds Work?
The working of an arbitrage fund is based on exploiting price inefficiencies. Let’s take a simple example to understand:
Suppose the shares of Company X are trading at ₹1,000 in the cash (spot) market and at ₹1,020 in the futures market.
The fund manager:
- Buys the stock in the spot market at ₹1,000
- Sells the same quantity in the futures market at ₹1,020
At the end of the month, when both contracts settle, the prices converge. Let’s say both end at ₹1,015.
The fund sells the spot position for ₹1,015, making ₹15 per share, but buys back the futures at ₹1,015, losing ₹5 per share on that leg. Net result? A profit of ₹10 per share—risk-free and market-neutral.
Such price mismatches are not just found between spot and futures markets but also across different stock exchanges. For instance, if a stock trades at ₹1,000 on NSE and ₹1,002 on BSE, buying on one and selling on the other locks in ₹2 profit per share. As traders and funds keep exploiting such gaps, prices across exchanges gradually become uniform, ensuring market efficiency.
So, if these opportunities are momentary, why would investors still look at them? The answer lies in the unique benefits arbitrage funds offer.
Benefits of Investing in Arbitrage Mutual Funds
While arbitrage funds don’t promise high returns, their risk-reward profile makes them appealing under specific market conditions.
1. Low-risk Nature
Since trades are hedged, one position offsets the other, and the risk of market movements is largely neutralized. Even if the overall market falls, the fund’s profit (from locked-in spreads) remains intact. This makes arbitrage funds suitable for conservative investors or those seeking short-term parking options for idle money.
2. Consistent Returns in Volatile Markets
Arbitrage thrives on volatility. The more the price fluctuations, the greater the spread between cash and futures, the higher the potential returns. Periods of market uncertainty, where others hesitate, can actually work in favor of arbitrage strategies.
3. High Liquidity
Unlike fixed deposits or long-term debt funds, arbitrage funds allow you to redeem units easily, usually within a few business days. This provides flexibility without locking your money for long durations.
4. Tax Efficiency
Though they function like debt instruments in behavior, arbitrage funds are taxed like equity funds. This gives them a significant edge over traditional short-term investments such as liquid funds or bank deposits.
5. Better Alternative to Savings or Liquid Funds
For investors looking to park surplus cash for a few months but still earn better returns than savings accounts, arbitrage funds can be an efficient short-term solution—especially during periods of market volatility.
Despite their reputation for stability, arbitrage funds are not without vulnerabilities. A closer look at the risks helps investors weigh potential trade-offs effectively.
Risks Associated with Arbitrage Funds
Arbitrage funds may appear calm on the surface, but subtle market forces can ripple through their returns. Let’s uncover where the real risks lie.
1. Market Dependency
Arbitrage opportunities arise mainly when markets are volatile. In stable or dull markets, spreads shrink, and so do returns. During such times, fund managers may increase allocation to short-term debt instruments, which generally yield lower returns.
2. Short-term Focus
These funds are best suited for short-term parking—say 3 to 6 months. Investors expecting long-term compounding like equity funds may be disappointed, as returns stay in a narrow range.
3. Execution Risk
Since profits depend on quick trades between markets, even a slight delay in execution or a change in spread can impact realized returns. This requires precise fund management and timing.
4. Expense Ratio Impact
Because the fund needs to execute several buy-sell transactions, costs can add up. A higher expense ratio can marginally affect the net returns.
Not only risks, but taxation also often plays an important role for investors while deciding how to place arbitrage funds in their portfolios. Let’s see how taxes affect these funds.
Arbitrage Fund Taxation in India
Since arbitrage funds invest at least 65% in equities, they are classified as equity-oriented schemes for taxation purposes. That makes their tax treatment more favorable than debt funds.
Here’s how the taxation works:
- Short-term Capital Gains (STCG): If you redeem your investment within 1 year, gains are taxed at 20%.
- Long-term Capital Gains (LTCG): If you hold for more than 1 year, gains are taxed at 12.5% without indexation, and there’s a ₹1.25 lakh exemption per financial year.
- Tax Deducted at Source (TDS): 10% is deducted if the gain exceeds ₹5,000 in a year. If you don’t provide a PAN, TDS rises to 20%.
- Dividend Taxation: If the fund distributes dividends, they are taxed at your applicable income slab once the dividend exceeds ₹5,000 in a financial year.
This taxation model gives arbitrage funds a unique advantage—the predictability of returns with the taxation benefits of equity.
But should every investor include it in their portfolio? Let’s see who stands to benefit the most.
Who Should Invest in Arbitrage Funds?
Arbitrage funds are best suited for investors who:
- Want to park funds temporarily (3–6 months) without exposing themselves to high market risk.
- Prefer better returns than savings accounts but don’t want the volatility of equities.
- Are looking for tax-efficient alternatives to liquid or ultra-short-term debt funds.
- Need a place to hold funds while waiting for better long-term investment opportunities.
For investors in higher tax brackets, arbitrage funds can be particularly attractive due to equity taxation and relative safety.
Conclusion
Arbitrage opportunities exist only for short moments, and exploiting them demands speed, expertise, and timing. For retail investors, catching these opportunities directly is nearly impossible. That’s where arbitrage mutual funds come in—they systematically capture these fleeting gaps to deliver consistent; low-risk returns.
While they won’t make you rich overnight, they can play a steady role in your portfolio—especially for parking idle funds or balancing risk in uncertain markets.
In a way, arbitrage funds combine the stability of debt with the tax efficiency of equity—a rare combination for cautious investors seeking balance over thrill.
