If you’ve ever wished for an investment option that sits comfortably between a fixed deposit and an equity fund, you’re not alone. Many investors want better returns than savings accounts, but without the roller-coaster ride of the stock market. This is exactly where an arbitrage fund quietly shines.
An arbitrage fund is often described as a low-risk equity mutual fund—which sounds confusing at first. How can something be equity-oriented and low risk at the same time? 🤔
That’s the magic of arbitrage.
In this detailed guide, we’ll break down what an arbitrage fund is, how it works, who should invest in it, its taxation, risks, returns, and how it compares with other popular options like liquid funds and fixed deposits. No jargon. No hype. Just clear, practical explanations you can actually use.
What Is an Arbitrage Fund? (Simple Definition)
An arbitrage fund is a type of equity mutual fund that aims to generate returns by exploiting price differences of the same stock in different markets—usually the cash (spot) market and the futures market.
In simple words:
An arbitrage fund buys a stock at a lower price in one market and sells it at a higher price in another market, locking in a near risk-free profit.
Because the buy and sell happen almost simultaneously, the fund is not betting on market direction. Instead, it profits from temporary mispricing.
How Does an Arbitrage Fund Work? (With a Real-Life Example)
Let’s understand arbitrage with a very simple example.
Example:
- Reliance share price in cash market: ₹2,500
- Reliance futures price (1-month contract): ₹2,520
What the arbitrage fund does:
- Buys Reliance in the cash market at ₹2,500
- Sells Reliance futures at ₹2,520
- Locks in a ₹20 per share difference (before costs)
On expiry, the cash and futures prices converge. The fund earns the spread, regardless of whether the market goes up or down.
👉 This is why an arbitrage fund is considered market-neutral.
Why Are Arbitrage Funds Classified as Equity Funds?
This surprises many investors.
Even though arbitrage funds behave like low-risk debt instruments, they are classified as equity mutual funds because:
- At least 65% of their portfolio is invested in equities
- The equity exposure is hedged using derivatives (futures)
Why this matters
Because of this classification, arbitrage funds enjoy equity-style taxation, which is often more tax-efficient than debt funds or fixed deposits—especially for short-term investors.
Key Features of an Arbitrage Fund
Let’s summarize the core characteristics of an arbitrage fund:
- ✅ Low risk compared to pure equity funds
- ✅ Market-neutral strategy
- ✅ Equity taxation benefits
- ✅ Better post-tax returns than FDs for many investors
- ✅ Suitable for short to medium-term goals
- ❌ Not designed for wealth creation like equity funds
Who Should Invest in an Arbitrage Fund?
An arbitrage fund is not for everyone—but for the right investor, it can be a perfect fit.
Arbitrage Funds Are Ideal For:
- Conservative investors looking for FD alternatives
- Investors with short-term surplus money (3–12 months)
- High tax-bracket individuals seeking tax efficiency
- First-time mutual fund investors
- Investors parking money during volatile markets
Arbitrage Funds May NOT Be Ideal For:
- Long-term wealth creation goals
- Investors seeking high returns
- Those comfortable with high equity volatility
Arbitrage Fund vs Liquid Fund vs Fixed Deposit
Let’s compare these popular options side by side.
Comparison Table
| Feature | Arbitrage Fund | Liquid Fund | Fixed Deposit |
|---|---|---|---|
| Risk Level | Low | Very Low | Very Low |
| Returns (Typical) | 5.5% – 7% | 4.5% – 6% | 5% – 7% |
| Taxation | Equity taxation | Debt taxation | Fully taxable |
| Lock-in | None | None | Usually locked |
| Market Impact | Minimal | None | None |
| Best For | Tax-efficient parking | Emergency funds | Capital protection |
📌 Key takeaway:
For investors in the 30% tax bracket, an arbitrage fund often delivers better post-tax returns than both liquid funds and fixed deposits.
Taxation of Arbitrage Funds (Very Important!)
This is where arbitrage funds truly stand out.
Short-Term Capital Gains (STCG)
- Holding period: Less than 1 year
- Tax rate: 15% flat
Long-Term Capital Gains (LTCG)
- Holding period: More than 1 year
- Gains up to ₹1 lakh: Tax-free
- Above ₹1 lakh: 10% without indexation
Compare This With FD Taxation
- FD interest is taxed at your slab rate (20%–30%)
- Even short-term gains in arbitrage funds can be more tax-efficient
👉 This tax advantage is one of the biggest reasons arbitrage funds are popular among salaried professionals.
What Returns Can You Expect From an Arbitrage Fund?
Let’s be realistic—arbitrage funds are not return boosters.
Typical Returns Range
- 5% to 7% annually, depending on:
- Market volatility
- Interest rate environment
- Availability of arbitrage opportunities
Important Note
Higher market volatility often means better arbitrage opportunities, which can slightly improve returns.
Are Arbitrage Funds Risk-Free?
No investment is 100% risk-free, and arbitrage funds are no exception.
Key Risks in Arbitrage Funds
- Execution Risk
Delay in executing buy/sell orders can reduce spreads. - Low Opportunity Risk
During calm markets, arbitrage opportunities shrink. - Expense Ratio Impact
High expense ratios can eat into already modest returns.
📌 The good news:
These risks are significantly lower than those in equity funds.
How Do Arbitrage Funds Invest Their Money?
A typical arbitrage fund portfolio includes:
- 65–80%: Equity + equity derivatives (hedged)
- 20–35%: Debt & money market instruments
This debt portion adds stability and liquidity.
When Should You Invest in an Arbitrage Fund?
Timing isn’t critical, but arbitrage funds are especially useful during:
- High market volatility
- Rising interest rate uncertainty
- Short-term goal planning
- Temporary parking of large sums (bonus, property sale, etc.)
How to Choose the Best Arbitrage Fund?
Not all arbitrage funds are the same. Here’s what to check:
1. Expense Ratio
Lower is better. Since returns are limited, costs matter a lot.
2. Fund Size (AUM)
Very large funds may struggle to find opportunities.
3. Fund House Experience
Established AMCs manage execution better.
4. Past Consistency
Look for stable returns, not the highest ones.
Common Myths About Arbitrage Funds
Myth 1: Arbitrage funds are like equity funds
❌ Not true. They don’t depend on market direction.
Myth 2: Returns are guaranteed
❌ No mutual fund guarantees returns.
Myth 3: They are only for experts
❌ Even beginners can invest comfortably.
How to Invest in an Arbitrage Fund?
You can invest in an arbitrage fund through:
- Mutual fund apps
- AMC websites
- Demat platforms
- Financial advisors
Investment Modes
- Lump sum – Ideal for parking money
- SIP – Less common, but possible
Arbitrage Fund for Retired and Near-Retirement Investors
For investors above 45–50 years, arbitrage funds can:
- Act as a tax-efficient debt alternative
- Reduce portfolio volatility
- Provide stable, predictable returns
They work well as a temporary holding before moving money into safer or goal-based investments.
Pros and Cons of Arbitrage Funds
Pros
- Tax-efficient
- Low volatility
- Equity classification benefits
- No lock-in
Cons
- Limited upside
- Dependent on market spreads
- Not suitable for long-term growth
Is an Arbitrage Fund Worth It?
An arbitrage fund is not flashy. It won’t make headlines or double your money. But what it does offer is stability, predictability, and tax efficiency—three things many investors value deeply.
If you’re looking for:
- A smart alternative to fixed deposits
- A place to park short-term money
- Lower risk with better post-tax returns
👉 Then an arbitrage fund deserves a spot in your portfolio.
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💡 Next step for you:
Review your short-term savings or idle cash. If it’s sitting in a savings account or FD, explore arbitrage funds and see if they can improve your post-tax returns.
👉 Want help choosing the right arbitrage fund or building a balanced portfolio? Keep exploring our blog for practical, no-nonsense personal finance guides!
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