What are Arbitrage Funds? Basics & Benefits

Markets move unpredictably - up one day, down the next. But some funds don’t rely on direction at all. Arbitrage funds make money from price gaps between cash and futures markets. They’re treated as equity for tax purposes but act like low-risk investments, perfect for parking short-term cash.

This blog will cover:

• The basics of arbitrage funds

• How they work in different markets

• When and why to use them

• The ideal type of investor

If you’ve wanted the safety of debt with the tax benefits of equity, this guide will show you how arbitrage funds fit the bill.

What is an Arbitrage Fund?

Not all investors want to chase stock rallies. Some want peace of mind and tax efficiency. Arbitrage funds deliver both. They profit from temporary price differences between markets, earning steady returns even when markets move sideways.

Main features:

• Taxed as equity, safer than typical equity funds

• Ideal during volatile markets

• Usually low-risk and short-term in nature

• Depend on market opportunities, not direction

For people who prefer a safe place for idle money but still want equity-style tax treatment, arbitrage funds can be considered as one of the alternatives.

How Arbitrage Funds Work (Example of price mismatch)

Here’s a simple example that shows how arbitrage works and why it stays safe even if prices move up or down.

Let’s assume:

• The stock price in the cash (spot) market is ₹1,200.

• At the same time, its futures contract is trading at ₹1,230.

• The fund buys the stock in the spot market and sells it in the futures market.

Now let’s look at different scenarios at expiry:

No matter where the price moves, the gain stays the same - ₹30 per share. That’s the essence of arbitrage: risk-free profit from price differences, not from predicting market direction.

Benefits of Arbitrage Funds

Before choosing, it’s helpful to know what makes arbitrage funds stand out:

Low risk

One of the biggest advantages of arbitrage funds is their low risk. They don’t rely on whether the market goes up or down. Instead, they lock in profits by buying and selling at the same time in two markets. This shields them from price swings. For investors who prefer stability over speculation, arbitrage funds provide a safe, market-linked way to earn modest, predictable returns.

Tax efficiency

One big plus is how they’re taxed. Even though they behave like debt funds, the government counts them as equity. That means you may pay less tax compared to many short-term debt funds. Over time, this can help you keep more of your earnings.

Liquidity

Arbitrage funds are easy to get in and out of. You’re not locked in. If you need your money, you can withdraw without penalty, and it’s usually back in your bank within a couple of days. This makes them useful for both investors and businesses looking for flexible parking options.

Who should invest?

Arbitrage funds are not for everyone, but they suit certain types of investors well. Here’s who can consider them:

Best suited for:

• Investors looking for low-risk, market-linked returns

• People who want better tax treatment than most debt funds

• Those parking money for 3–12 months

• Conservative investors avoiding stock market swings

• Businesses and HNIs needing a safe place for large funds

Risks & Limitations of Arbitrage Funds

While arbitrage funds are low-risk, they are not completely risk-free. Here are the main limitations to keep in mind:

1. Market Conditions Can Affect Returns

• If markets are very calm, price gaps may be smaller.

• Fewer opportunities can reduce overall profits.

2. Liquidity Risk

• Some stocks may not be liquid enough to execute trades quickly.

• This can delay profits or slightly affect returns.

3. Expense Ratio Impact

• Fund management fees can eat into small arbitrage gains.

• Always compare expense ratios before choosing a fund.

4. Not a High-Growth Option

• Returns are modest

• Best suited for safety and stability, not wealth multiplication.

5. Tax Rules May Change

• Though currently taxed like equity funds, future changes can affect post-tax returns.

6. Opportunity Cost

• Money in arbitrage funds may earn less than other aggressive investments in a bull market.

In short, they’re safe and steady but should be chosen with realistic expectations.

Conclusion

Arbitrage funds are all about making the most of small opportunities safely. They earn from market gaps, not trends, offering stability and tax efficiency. While they may not replace high-growth equity investments, they give you confidence that your money is working in the right way. Because sometimes slow and steady truly win the race!

Disclaimers:

The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision.

Investors are advised to consult their Tax Consultant or Financial Advisor to determine tax benefits applicable to them.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.