How do arbitrage funds work in mutual fund investing?

Arbitrage mutual funds work by taking advantage of price differences in the cash and derivatives (futures) markets. Fund managers buy a stock in the cash market and simultaneously sell the same stock in the futures market to lock in a risk-free profit. These funds are considered low-risk and are especially attractive during volatile or uncertain market conditions.

1. What Is an Arbitrage Mutual Fund?

An arbitrage mutual fund is a hybrid scheme that exploits the price gap between equity spot and futures markets. Since both trades happen at the same time, the risk is minimal, and the profit is almost locked in.

Key Characteristics:

• Low-risk and suitable for conservative investors
• Short-term gains based on arbitrage opportunities
• Taxed like equity mutual funds if held for over one year
• Ideal in volatile or uncertain equity markets

2. How Do Arbitrage Funds Actually Work?

These funds function based on arbitrage opportunities that arise due to temporary price mismatches:

a) Cash-Futures Arbitrage

Suppose a stock trades at ₹100 in the cash market and ₹102 in the futures market. The fund manager buys the stock at ₹100 and sells a futures contract at ₹102. On expiry, both positions are closed, and a ₹2 profit is earned per share, regardless of market direction.

b) Risk-Free Profits

Since both buy and sell happen at the same time, the fund is hedged. There’s little or no impact even if the market crashes, as gains are locked in during the trade initiation.

3. When Are Arbitrage Funds Most Effective?

Arbitrage funds are particularly useful in the following scenarios:

• Volatile markets: Increased volatility often leads to higher price gaps between cash and futures markets.
• Uncertain equity conditions: Investors who want equity-like tax treatment but lower risk prefer arbitrage funds.
• Short-term parking: These funds offer better returns than liquid or overnight funds in certain conditions.

4. Taxation of Arbitrage Mutual Funds

Though they act like debt funds in terms of structure, arbitrage funds are taxed like equity funds:

• Short-term capital gains (less than 1 year): Taxed at 15%
• Long-term capital gains (more than 1 year): Taxed at 10% above ₹1 lakh of gain

This tax efficiency makes them attractive compared to fixed deposits or short-term debt funds.

5. Pros and Cons of Arbitrage Mutual Funds

Advantages:

• Low volatility and low risk
• Better post-tax returns than FDs for short periods
• Ideal for risk-averse investors during volatile times

Limitations:

• Returns are not guaranteed
• Require arbitrage opportunities, which may reduce in stable markets
• Short-term gains may be lower compared to aggressive equity funds

6. Who Should Invest in Arbitrage Funds?

Arbitrage funds suit the following investor profiles:

• Investors with a low-risk appetite
• People looking for equity tax benefits without taking equity risk
• Short-term investors seeking better returns than liquid funds or FDs

They can also be used to park funds temporarily when you are waiting to invest in other instruments but don’t want to keep idle money in savings accounts.

Arbitrage mutual funds are a smart choice for investors who prefer safety with the added benefit of equity taxation. They use market inefficiencies to generate small but consistent profits, without taking on the full risk of the stock market. If you’re looking for a low-risk mutual fund option with stable returns, arbitrage funds can be a great addition to your portfolio. You can easily explore and compare the best arbitrage funds on platforms like Angel One and start investing with confidence.