How do arbitrage mutual funds generate returns?

Arbitrage mutual funds generate returns by exploiting temporary price differences between equity cash markets and derivative markets. Fund managers simultaneously buy stocks in the spot market and sell equivalent futures contracts in the derivatives market to lock in profits. These opportunities arise due to price inefficiencies between the two markets, and the spread captured becomes the return for investors, offering a low-risk and tax-efficient alternative to traditional debt funds.

1. What Are Arbitrage Mutual Funds?

Arbitrage mutual funds are hybrid funds that mainly invest in equities and derivatives to earn risk-free profits from price differences. These schemes take advantage of market inefficiencies by buying low in one market and selling high in another at the same time. Most arbitrage funds have a minimum 65% allocation to equities to qualify for equity taxation, while the rest may be parked in debt instruments.

Why Investors Prefer Them:

• Low volatility compared to pure equity funds
• Taxed like equity funds (favorable capital gains tax)
• Ideal for short-term investments with less risk

2. How Do Arbitrage Mutual Funds Generate Returns?

Returns are generated through a strategy called cash-futures arbitrage. Here's how it works:

a) Spot-Futures Price Difference

Fund managers identify a stock that trades at ₹100 in the spot market but at ₹102 in the futures market. They buy the stock in the spot market and simultaneously sell it in the futures market. When both positions are squared off at the end of the contract, the ₹2 spread becomes the fund’s profit (excluding costs).

b) Market Inefficiencies

These price differences occur due to market demand, volatility, liquidity constraints, or interest rate expectations. Arbitrage funds benefit from these short-lived inefficiencies without taking direct market exposure.

c) Low-Risk Strategy

Since both buy and sell trades are executed simultaneously for the same quantity, the market risk is minimal. The return depends primarily on the spread, not market direction.

3. How Are Returns Realized in Arbitrage Funds?

Profits are booked when the futures contracts expire, and both legs of the arbitrage trade are settled. These are typically short-term positions, and fund managers repeat this cycle multiple times within a month, compounding returns over time. Apart from this, the debt portion of the portfolio also generates interest income.

Sources of Returns:

• Spread between spot and futures
• Interest from debt instruments
• Occasional dividend income from underlying equity holdings

4. What Are the Risks Involved?

Although arbitrage funds are considered low-risk, they do have some inherent risks:

• Reduced arbitrage opportunities: In highly efficient markets, price gaps may narrow.
• Liquidity risk: Low liquidity in futures or certain stocks can impact trade execution.
• Execution risk: Delay or mismatch in trades can affect returns.

5. Tax Benefits of Arbitrage Mutual Funds

These funds are taxed like equity-oriented funds because of their 65%+ equity exposure, making them more tax-efficient than debt funds for short-term investors.

Taxation Rules:

• Short-term Capital Gains (STCG): 15% if held for less than 1 year
• Long-term Capital Gains (LTCG): 10% for gains above ₹1 lakh (if held for more than 1 year)

This taxation makes arbitrage funds suitable for high-tax-bracket investors looking for short-term parking options.

Arbitrage mutual funds offer a unique way to earn steady returns by using market inefficiencies. With minimal equity market risk and favorable tax treatment, they act as a smart short-term investment alternative to liquid or debt funds. However, their performance depends on the availability of arbitrage opportunities and prevailing interest rates. For investors seeking stability with better tax efficiency, arbitrage funds can be a suitable addition to a well-diversified portfolio.