Arbitrage Funds in India: A Quick Guide with Example

1. What Are Arbitrage Funds?

Arbitrage funds are hybrid mutual funds that aim to generate low-risk, debt-like returns by exploiting price differences between the cash (spot) market and the futures market for the same stock as their primary strategy. These differences are typically small but can be systematically captured.

To qualify as equity funds for taxation purposes, arbitrage funds maintain at least 65% exposure to equity-related instruments, even though their return profile behaves more like fixed income. The rest is usually parked in debt funds. More details can be found in this article.

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2. How Do Arbitrage Funds Work?

Here's how a typical arbitrage trade works:

Suppose Reliance Industries is trading at ₹1272.3 in the cash market.
At the same time, its futures contract (say, 41 days to expiry) is trading at ₹1280.4.

An arbitrage fund would:

• Buy 500 shares of Reliance in the cash market.
• Sell 1 Reliance futures contract (lot size = 500) at ₹1280.

At expiry, futures and cash prices converge. The fund then:

• Sells the 500 shares in the cash market.
• Buys back the futures contract.

Calculation:

Reliance Cash Price = ₹1272.3
Reliance Futures Price (41 DTE) = ₹1280.4
Spread = ₹8.1
Lot Size = 500 shares
Profit = ₹8.1 × 500 = ₹4,050 (before costs)

Capital Required: For such hedged arbitrage trades, margin requirements are around ₹7,50,000 per lot.

Return:

Absolute Return = ₹4,050 / ₹7,50,000 = 0.54%

Annualised Return (CAGR-style over 41 days):

(1 + 0.0054)^(365/41) - 1 = (1.0054)^8.902 - 1 = 1.0502 - 1 = 0.0502 ≈ 5.02%

This is pre-cost. Post-tax and post-cost returns might be slightly lower, but for high-net-worth investors or institutions, this offers a tax-efficient alternative to fixed deposits and liquid funds.

This locked-in spread is considered low-risk if both legs are held till expiry.

You can see a more detailed calculation of this with real market data in this article.

3. Taxation of Arbitrage Funds (Post-Budget 2024)

Despite offering fixed-income-like returns, arbitrage funds are taxed as equity mutual funds, providing a significant advantage over debt funds and fixed deposits, especially for those in higher tax brackets.

Effective from July 23, 2024, the tax structure is as follows:

These changes were introduced in the Union Budget 2024 to simplify and rationalize the capital gains tax framework.

So if you’re in the 25% or 30% tax bracket, it makes sense to park your short term cash in arbitrage funds, rather than in traditional debt instruments.

4. Who Should Invest in Arbitrage Funds?

Arbitrage funds are ideal for:

• Investors in high tax brackets seeking low-risk returns
• Individuals looking to park money for 3–6 months
• Those who want liquidity with tax efficiency

They are not suitable for investors seeking high returns or long-term capital growth.

5. Risks to Consider

• Diminishing spreads in low-volatility markets
• Execution slippage or inability to completely hedge
• Costs like brokerage, STT, stamp duty, and GST eating into returns

While considered low-risk, arbitrage funds aren't entirely risk-free. Proper fund management is essential to ensure predictable, tax-optimized returns.

On top of this, there are some non-obvious risks we discuss in our article, Arbitrage Funds - A Deep Dive.

Conclusion

Arbitrage funds offer a compelling option in a high-tax environment for generating low-risk, short-term returns. With favorable equity taxation and a built-in hedging mechanism, they function like the best of both worlds: equity classification with fixed income behavior.

In a world where tax efficiency is paramount, arbitrage funds are a tool every serious investor should consider.