What is Arbitrage Fund? Meaning, Taxation, Misconceptions

At the core level, arbitrage funds utilize the price differences between similar securities in different markets, occupying a unique place in the stock market that combines the attributes of both equity and debt instruments. This combination creates a relatively low-risk investment direction for potential investors. 

In this article, we take a closer look at what is arbitrage fund, best arbitrage funds, how it works, arbitrage fund taxation, and a lot more!

Arbitrage Funds - Meaning

Arbitrage funds are hybrid mutual funds that capitalise on the pricing mismatch of the cash (spot) market and the derivatives (futures) market. They act as a low-risk investment option as the returns come from the spread, and not from predicting whether the market will go up or down. 

For example, if a stock is trading at Rs 1,000 in the cash market and Rs 1,020 in the futures market, an arbitrage fund will buy it in the cash market and sell it in the futures market simultaneously. At the end, when the prices converge at expiry, the fund earns the Rs 20 difference as profit.

Features of Arbitrage Funds

Arbitrage funds stand out due to their strategic structure and risk-mitigating nature. The following features highlight why they are increasingly favoured in volatile or uncertain market conditions:

1. Price difference strategy: Arbitrage funds earn from short-term price gaps between the cash and futures markets, not from market direction.

2. Risk control: They reduce risk by holding opposite positions in two markets, shielding the portfolio from major price swings.

3. Thrives on volatility: Market volatility creates more price gaps, helping arbitrage funds generate better returns during fluctuations.

4. Conservative approach: By regulation, arbitrage funds invest at least 65% in equities, but due to their hedged strategy, they act like low-risk funds while enjoying equity tax benefits.

How Do Arbitrage Funds Work?

Now that we have understood what is arbitrage fund, it is essential to see how they actually function. Here's a step-by-step look at how these funds generate returns.

Step 1: Spotting a price mismatch

In the first step, the fund manager looks for stocks that are priced lower in the cash market and higher in the futures market. For instance, if a stock is available at Rs 100 in the cash market and Rs 102 in the futures market, there's a Rs 2 gap to take advantage of.

Step 2: Executing paired trades

To lock in this difference, the fund simultaneously buys the stock in the cash market and sells it in the futures market at the higher price.

Step 3: Booking the spread

By the time the futures contract expires, the prices of both markets typically align. The fund then closes both positions, capturing the Rs 2 profit per share, irrespective of whether the stock price went up or down overall.

Step 4: Managing unused capital

And when there are fewer arbitrage opportunities, the fund temporarily invests surplus money in low-risk instruments like short-term debt or money market securities to maintain consistent returns.

Advantages of Arbitrage Funds

Now that we have seen the list of arbitrage funds, we need to understand that these funds come with a set of advantages that make them an appealing option for low-risk investors. Below, let’s explore some of the key benefits that they offer:

Low-risk:

Arbitrage funds carry minimal risk, and the credit goes to their hedged investment strategy. This benefit makes the conservative investors go for arbitrage fund investments. 

Favourable tax treatment: 

If the arbitrage funds are held for over a year, gains from these funds are taxed as long-term capital gains. And this becomes favorable when you fall under high tax brackets. 

Built-in diversification:

These arbitrage funds typically invest across a wide range of sectors and instruments, helping spread out the risk of the investors and reducing the impact of any single market movement.

Easy access to funds:

Arbitrage funds provide strong liquidity, allowing investors to exit and access their money with minimal delay, usually within one business day.

Disadvantages of Arbitrage Funds

Despite their low-risk appeal, arbitrage funds have a few limitations that investors must understand:

Higher management costs:

Arbitrage funds require active monitoring and strategy execution, which often leads to higher expense ratios than regular debt funds.

Limited return potential:

Since the profit depends on small pricing gaps, arbitrage funds usually generate modest returns compared to traditional equity funds.

Exposure to interest rate changes:

A portion of the fund is parked in short-term debt instruments. When interest rates rise, the value of these holdings may fall, affecting the fund’s net asset value (NAV).

Dependence on market volatility:

The price difference strategy works best in volatile markets. In periods of low volatility, arbitrage opportunities shrink, reducing the fund’s return potential.

Taxation of Arbitrage Funds

Arbitrage funds qualify as equity mutual funds for tax purposes because they allocate at least 65% of their portfolio to equities or equity-linked instruments. This status enables them to benefit from the favorable tax treatment given to equity schemes.

Now, let us look at how these arbitrage funds are taxed when they become a Short Term Capital Gain or Long Term Capital Gain. 

Short-Term Capital Gain Tax

The profit earned from selling your arbitrage fund units that you have held for less than 12 months will be classified as Short-term capital gains. 

Long-Term Capital Gain Tax

The profit earned from selling your arbitrage fund units that you have held for 12 months or more will be classified as Long-term capital gains. 

Common Misconceptions About Arbitrage Funds

Despite their growing popularity, arbitrage funds are often misunderstood. Let us clear up some of the most common misconceptions surrounding them:

Arbitrage funds are completely risk-free.

Many people believe that arbitrage funds carry no risk due to the hedging strategy. But in reality, factors like execution risk, flat market risk, and temporary negative returns will carry inherent risks within them, which can be ignored.

Arbitrage funds offer higher returns.

Some people expect high returns similar to equity funds. But in reality, arbitrage funds provide stable, moderate, and generally comparable or slightly better returns than liquid funds, as their profits come from small, hedged price differences, and not market growth. 

Arbitrage funds perform well in rising markets.

Many investors assume that arbitrage funds benefit from a rising market. But unlike equity funds, arbitrage funds do not benefit from market direction. Their performance relies on volatility, not market rallies or trends.

Arbitrage funds are just like liquid funds.

While both are considered low-risk, arbitrage funds invest primarily in equities and derivatives, whereas liquid funds invest in short-term debt instruments. Their strategies, taxation, and risk-return profiles are different. 

Arbitrage funds are a substitute for pure equity funds.

Due to their equity concept, arbitrage funds are sometimes seen as an alternative for long-term growth. But in reality, they yield low returns from short-term market inefficiencies, making them unsuitable for wealth creation. 

Arbitrage Funds vs Liquid Funds

Arbitrage funds and liquid funds both cater to short-term investors, but they operate on different principles. Here’s a quick comparison of these two funds in a structured manner:

Best Arbitrage Funds in India

For investors considering this category, here’s a list of popular arbitrage mutual funds currently available in the market with consistent returns:

(The above CAGR values are recorded as of 11th July, 2025).

How to Invest in Arbitrage Funds?

For those interested in adding arbitrage funds to their portfolio, here’s a step-by-step guide as to how you can invest in arbitrage funds. 

Step 1: Download the Rupeezy trading app from the Google Play Store or Apple App Store, and open your demat and trading account.

Step 2: Once your accounts are open, fund the trading account through your linked bank account.

Step 3: Now navigate the mutual funds section and click on the ‘arbitrage’ fund category which comes under hybrid funds.

Step 4: Next, select the fund that you want to invest in and decide if you want to invest through lupmsum or SIP.

Step 5: You can now enter your investment amount and pay.

Step 6: Once invested, you can monitor your arbitrage funds’ performance and its returns to plan future contributions. 

Conclusion

Arbitrage funds present a unique investment option that combines the benefits of equity taxation with relatively low risk. By leveraging price differences between the cash and derivatives markets, these funds aim to generate stable returns, especially in volatile market conditions. 

While not entirely risk-free, their hedged strategy makes them an attractive choice for conservative investors seeking short-term to medium-term investment options with better tax efficiency than traditional debt funds. However, like any financial instrument, it’s important to understand their limitations and ensure they align with your investment goals and risk profile before investing!

FAQs

Q1. How do arbitrage funds make money?

Arbitrage funds generate returns by taking advantage of short-term price differences between the cash (spot) market and the futures market. They purchase the asset in the market where it’s undervalued and sell it simultaneously in the market where it’s priced higher, securing a profit from the difference in prices.

Q2. Is there any risk in arbitrage funds?

Arbitrage funds are relatively low-risk investments as they make use of the price differences rather than relying on the market direction. But few aspects like execution risk, fund manager’s performance risk, interest rate risks all add up to the risky factors of arbitrage funds. 

Q3. Are arbitrage funds better than FD?

Arbitrage funds may serve as a more tax-efficient alternative when compared to Fixed Deposits for investors in higher tax brackets, offering the potential for better post-tax returns. However, FDs provide assured returns and capital protection, making them a safer choice for highly risk-averse individuals. 

Q4. Is arbitrage legal in India?

Yes, arbitrage is legal in India, but intraday cross-exchange arbitrage without delivery is not permitted. 

Q5. Is arbitrage fund tax free?

No, arbitrage funds are not entirely tax-free but they offer tax-benefits like equity funds. Meaning, for STCG, the tax rate is 20%, and for LTCG, the tax rate is 12.5% without indexation benefit. However, for LTCG, Rs 1.25 lakh exemption per financial year is allowed.