Stock Market · Mutual funds, deeper

Arbitrage funds

Arbitrage funds occupy a unique niche: they generate debt-like returns (6-8%) but are taxed as EQUITY funds. After the 2023 debt fund tax changes, arbitrage funds became one of the most tax-efficient short-term parking options.

How arbitrage funds work

The fund manager exploits price differences between cash market and futures market.

Example: Reliance trades at ₹2,800 in cash market and ₹2,810 in futures market.

• Buy Reliance in cash at ₹2,800
• Sell Reliance futures at ₹2,810
• Lock in ₹10 spread when prices converge at expiry

These spreads exist due to financing costs and demand-supply differences. They're small but reliable.

Why they're classified as equity

SEBI rules: funds with 65%+ in equity (which arbitrage funds have via cash positions) are classified as equity funds for tax purposes.

The tax advantage

Holding period > 1 year:

• Arbitrage fund: 12.5% LTCG (with ₹1.25L exemption)
• Debt fund: slab rate (potentially 30%)

On ₹10 lakh held 18 months with ~7% return (₹1.05 lakh gain):

• Arbitrage fund tax: 0 (below ₹1.25L exemption)
• Debt fund tax (30% slab): ₹31,500

> Same returns. Drastically different post-tax outcome. This is the arbitrage fund's hidden advantage.

Limitations

• Returns depend on availability of arbitrage opportunities. Low in flat markets, high in volatile markets
• Capacity constrained, as more money flows in, spreads compress
• Returns can range 5-8% in a year; not always beat debt funds gross

When to use

• Parking money for 1+ year (LTCG advantage)
• High tax bracket investors looking for debt-like risk with equity-like tax
• Short-to-medium term goals where capital preservation matters

How the category differs internally

Arbitrage funds are close to a commodity. They're all chasing the same cash-futures spreads in the same handful of liquid stocks, so gross returns cluster tightly. What actually separates one from another:

• Expense ratio. On a 6-7% gross return, a 0.4% cost difference is a real slice of what you keep.
• Fund size against the size of the opportunity. A very large fund can't find enough spreads and parks the excess in debt, which dilutes the equity-taxation logic you came for.
• The unhedged equity portion. SEBI allows some room here, and a fund carrying more of it is carrying more risk than the category label implies.
• Exit load window, usually 15-30 days. Matters if your timeline slips.

All four are disclosed in the scheme information document and the monthly fact sheet, and AMFI's site lists every fund in the category with its AUM and expense ratio if you want to compare the whole field yourself.

Takeaway. Arbitrage funds: debt-like returns (6-8%) taxed as equity (12.5% LTCG with ₹1.25L exemption). After the 2023 debt fund tax change, they're the most tax-efficient option for 1+ year parking in higher tax brackets.