Arbitrage Funds Explained: Low Risk, Equity Taxation
Arbitrage funds earn from the small price gap between a stock in the cash market and the same stock in the futures market, not from the market going up. They buy the share, simultaneously sell an equal quantity of its futures contract, and pocket the difference when the two prices meet at expiry.
An arbitrage fund is an equity mutual fund category that runs fully hedged cash and futures positions, so its returns behave like a short term debt fund while its taxation follows equity rules. That combination is the entire reason the category exists.
Ahead: how the trade works, the numbers on one stock, why the tax treatment matters, and where these funds disappoint.
Where the return comes from
The cash futures spread
A stock’s futures price is usually a little higher than its cash price, because a futures buyer defers payment and that deferral carries a financing cost. As expiry approaches, the premium shrinks and the futures price converges toward the cash price.
An arbitrage fund takes both sides. Long the share, short the future, same quantity. Whatever the stock does, the gain on one leg offsets the loss on the other, and what remains is the spread captured on day one.
Why convergence is close to certain
On the last day of the contract, futures and cash must settle at the same level. That is a contractual outcome, not a forecast. So the spread is not a bet on direction; it is payment for supplying capital to the futures market.
Stock futures in India are physically settled on expiry, which suits a fund that already holds the shares. Most managers prefer to roll the short position into the next month when the spread there is attractive.
A worked example on one stock
Suppose a share trades at Rs 1,000 in cash and its near month futures at Rs 1,006. The spread is Rs 6, which is 0.6% of the cash price for roughly a month, or close to 7.2% annualised before costs.
Assume the lot size is 1,500 shares. The fund buys 1,500 shares at Rs 1,000, an outlay of Rs 15,00,000, and sells one futures lot at Rs 1,006. Now test two very different endings.
- Stock crashes to Rs 950. Cash leg loses Rs 50 per share, so Rs 75,000. Short futures gains 1,006 minus 950, which is Rs 56 per share, so Rs 84,000. Net gain: Rs 9,000.
- Stock rallies to Rs 1,080. Cash leg gains Rs 80 per share, so Rs 1,20,000. Short futures loses 1,080 minus 1,006, which is Rs 74 per share, so Rs 1,11,000. Net gain: Rs 9,000.
Same result both times. Rs 9,000 is simply Rs 6 multiplied by 1,500 shares, which is 0.6% on Rs 15,00,000. Direction did not matter. Out of that gross spread the fund still pays STT at 0.05% on the futures sell leg, exchange charges, brokerage and its own expense ratio, so investors receive less than 0.6%.
Why arbitrage funds get equity taxation
Because more than 65% of the portfolio sits in Indian equities, the scheme qualifies as an equity oriented fund even though the equity exposure is hedged away. The hedge protects the investor from price risk; the tax law looks at the holding, not the hedge.
| Feature | Arbitrage fund | Liquid fund | Debt fund bought after 1 April 2023 |
|---|---|---|---|
| Gains held over 12 months | 12.5%, first Rs 1.25 lakh of LTCG exempt | Slab rate | Slab rate under Section 50AA |
| Gains held 12 months or less | 20% | Slab rate | Slab rate |
| Source of return | Cash futures spread | Very short term interest accrual | Interest accrual and price change |
| Credit risk | Minimal on the hedged book | Low, high quality short paper | Depends on portfolio quality |
| Return steadiness | Varies with spreads | Steadier day to day | Varies with rates and credit |
For someone in the 30% slab the difference is real. A liquid fund return of 6.5% becomes about 4.55% after slab tax. An arbitrage fund return of 6% held beyond a year is taxed at 12.5%, so roughly 5.25% net, and possibly the full 6% if the gain fits inside the Rs 1.25 lakh annual LTCG exemption. The category rules are set out in this guide on how mutual fund returns are taxed.
For an investor in a lower slab, that advantage narrows sharply, and a liquid fund may be simpler and steadier.
When do arbitrage funds make sense?
- Parking money for three months to a couple of years for a known goal, where you want equity taxation and low price risk.
- Holding the cash portion of a portfolio while you stagger a lump sum into equity funds.
- Sitting on a large redemption you have not yet redeployed.
- Investors in the 30% slab already paying slab tax on liquid fund gains.
They fit an emergency fund poorly, because settlement plus a possible exit load makes them slower to exit than a liquid fund. They are also no substitute for equity exposure, since the hedge removes the upside you buy equity for.
What can go wrong?
Spreads are not fixed. When sentiment is flat or interest rates fall, futures premiums compress and monthly returns can drop noticeably. There have been stretches where arbitrage funds trailed plain money market funds for months.
Cash levels also rise when spreads are unattractive, and that idle portion earns money market returns, dragging the average down. Costs matter more than usual because the gross spread is thin. Exit loads are common for short holding windows, so check the scheme information document rather than assume; the mechanics are covered in this note on exit loads in mutual funds.
Risk note: these are low risk, not no risk. Daily NAV can dip, returns are not assured, and SEBI’s mandated riskometer, refreshed monthly, shows where the AMC itself places the scheme.
How to choose between two arbitrage funds
- Compare expense ratios, direct plan against direct plan. On a 6% gross return, a 0.35% cost gap is roughly a sixth of your net outcome.
- Check the exit load period against your holding plan. If you may exit in three weeks, a 30 day load window is a problem.
- Look at fund size. Very small funds struggle to spread positions across enough stocks; very large ones struggle to place capital when spreads are thin.
- Compare rolling one year returns rather than a single point return, so you see behaviour through both wide and narrow spread periods.
Frequently Asked Questions
Are arbitrage funds safer than liquid funds?
They carry different risks rather than strictly less risk. Liquid funds carry a little credit and interest rate risk on very short paper. Arbitrage funds carry almost no directional equity risk, but their return depends on futures spreads, which can shrink. Day to day NAV movement is usually slightly bumpier in an arbitrage fund.
How long should I stay invested in an arbitrage fund?
At least three months to clear any exit load window, and ideally beyond twelve months so gains qualify as long term at 12.5% with the Rs 1.25 lakh annual exemption available. Below three months the tax and cost advantage often disappears, and a money market fund is the cleaner choice.
Do arbitrage funds fall when the market crashes?
Not meaningfully, because every long share position is matched by a short futures position of the same quantity. What can happen in a sharp selloff is temporary distortion in futures pricing, which shows up as a small NAV wobble before expiry brings the two prices back together.
Can I run a SIP in an arbitrage fund?
Yes, and many AMCs accept instalments from as little as Rs 100 to Rs 500. That said, a SIP suits assets whose price swings enough for averaging to help. Arbitrage NAV barely swings, so a lump sum, or deposits as money arrives, works just as well.
Is an arbitrage fund the same as a balanced advantage fund?
No. An arbitrage fund stays fully hedged at all times. A balanced advantage fund deliberately varies its unhedged equity exposure using a model, so it participates in market moves and carries real equity risk along with higher potential return.
Key Takeaways
- Arbitrage funds capture the cash futures spread, so returns depend on how wide that spread is, not on market direction.
- A Rs 6 spread on a Rs 1,000 share held to expiry pays 0.6% for the month whether the stock ends at Rs 950 or Rs 1,080.
- Equity taxation applies because over 65% of assets sit in Indian equities: 12.5% beyond 12 months with the first Rs 1.25 lakh exempt, 20% below that.
- The tax edge is largest in the 30% slab and much smaller in lower slabs.
- Hold at least three months to clear exit load windows, and over twelve months for long term treatment.
- With a thin gross spread, direct plan expense ratios and exit load windows decide the winner between two similar funds.
