An arbitrage fund is a mutual fund that seeks to generate low-risk returns by exploiting short-term price differences in the equity market. Unlike traditional equity funds that depend on long-term capital appreciation, arbitrage funds earn by purchasing and selling the same security in different markets or segments. This locks in small profits without taking directional market risk.
In this blog, weтАЩll explain an arbitrage fund in simple terms, how it works, its key benefits, risks, tax advantages, and who should consider investing. Keep reading!
Introduction to Arbitrage Funds
An arbitrage fund seeks to make low-risk profits by taking advantage of temporary price differences for the same security across different markets or segments.
These funds are classified as equity-oriented hybrid funds, meaning they primarily invest in equities but also hold debt or money market instruments when no arbitrage opportunity exists.
To understand an arbitrage fund, think of it as a strategy where the fund manager simultaneously purchases a security at a lower price and sells it in another market at a higher price.
Unlike typical investments that rely on long-term price growth, arbitrage exploits short-term pricing inefficiencies.
How Arbitrage Funds Work
An arbitrage mutual fund functions by taking opposite positions in two different markets. For instance, if there’s a price gap, the fund may purchase a stock on one exchange and sell it on another.
Another common approach is to buy shares in the cash market and sell them in the futures market when a price difference exists.
These trades are executed simultaneously to lock in risk-free gains, though the actual difference in price is often small. Arbitrage fund managers make multiple trades daily to generate meaningful returns.
Role of Market Inefficiencies
Arbitrage opportunities arise due to market inefficiencies, such as pricing mismatches between exchanges or between the spot and futures markets. These mismatches are usually short-lived, and spotting them requires fast decision-making and automated systems. This is where a fund manager’s expertise is crucial.
Risk and Return Balance in Arbitrage Strategy
The returns of arbitrage funds are usually modest but come with significantly lower risk than pure equity funds. Since the buying and selling happen together, market direction has minimal impact on gains.
When arbitrage is unavailable, the fundтАЩs fallback is to invest in low-risk debt or money market instruments. This makes arbitrage funds suitable for conservative investors who want better post-tax returns than liquid funds or fixed deposits, especially in the short term.
Benefits of Investing in Arbitrage Funds
Arbitrage mutual funds offer an attractive middle ground for investors seeking a balance between stability and better returns than traditional debt instruments. They aim to deliver consistent returns with relatively low risk by exploiting short-term market inefficiencies. Here’s how you benefit:
Low-Risk Profile
An arbitrage fund carries lower risk than traditional equity funds because it involves simultaneous buy-sell trades. Since gains are locked in through price differentials, the fund is less affected by broader market volatility.
Tax Efficiency
Arbitrage funds enjoy equity mutual fund taxation because they invest at least 65% of their portfolio in equities or equity-linked instruments.
This classification gives them favorable tax treatment:
Short-Term Capital Gains (STCG): If you redeem units within 12 months, gains are taxed at 20% flat.
Long-Term Capital Gains (LTCG): If held for more than 12 months, gains over тВ╣1 lakh in a financial year are taxed at 10% (without indexation). However, after surcharges and cess, the effective LTCG tax can go up to ~12.5%.
Suitable for Short-Term Parking of Funds
Arbitrage funds can be a suitable option if you’re looking to park funds for a few months with minimal risk and better post-tax returns than a savings account or liquid fund. With low volatility and equity-like tax treatment, theyтАЩre ideal for conservative investors seeking short- to medium-term stability without locking in capital for long durations.
Risks and Limitations of Arbitrage Mutual Funds
Despite their benefits, arbitrage funds have certain limitations you must understand before investing. These risks may not be high, but they can impact your overall return and fund suitability.
Market Dependency
The availability of arbitrage opportunities depends on market conditions. In stable or low-volatility markets, minimal pricing mismatches may reduce the fundтАЩs ability to generate returns.
Limited Returns Compared to Equity
While arbitrage fund returns are relatively steady, they are also capped. The profit margin from each trade is small, so overall gains may not match those of pure equity funds, especially in a rising market.
Interest Rate Risk
When arbitrage opportunities are limited, the fund may invest in debt instruments. This exposes the fund to interest rate risk, as rising rates can cause a fall in these holdings’ NAV (Net Asset Value).
Who Should Invest in Arbitrage Funds?
An arbitrage fund is ideal for investors earning low-risk, tax-efficient returns while preserving capital. These funds are best suited for specific investor profiles and time horizons.
Ideal Investor Profile
If you have a low-risk appetite and prefer stable returns over high growth, an arbitrage mutual fund can be suitable. ItтАЩs especially helpful for:
- New investors want to enter the mutual fund space without taking on full equity risk.
- Conservative investors who want to reduce exposure to volatility.
- Individuals with surplus cash are looking to park funds for a few months.
However, itтАЩs important to understand that arbitrage fund returns are modest, and opportunities may not always be available. So, if you expect high equity-like gains, these funds may not match your expectations.
Short-Term vs. Long-Term Suitability
Arbitrage mutual funds work best for short to medium-term investment horizons тАФ typically 3 to 6 months. They can be a better alternative to savings accounts or liquid funds for parking idle funds or building an emergency corpus.
These funds are not ideal for long-term wealth creation, as the return potential is limited compared to diversified equity funds. But they hold up well across market cycles тАФ including bull, bear, and volatile phases тАФ by capitalising on short-term price differences.
Performance of Arbitrage Funds in India
On average, arbitrage mutual funds have delivered stable annualised returns over the years:
- 3-year average return: 7.21% p.a.
- 5-year average return: 5.92% p.a.
- 10-year average return: 6.38% p.a.
Here are some of the best arbitrage funds in India (based on 5-year annualised returns):
| Fund Name | 5-Year Return (p.a.) |
| Edelweiss Arbitrage Fund | 6.19% |
| UTI Arbitrage Fund | 6.03% |
| SBI Arbitrage Opportunities | 5.99% |
| JM Arbitrage Fund | 5.35% |
| Invesco India Arbitrage | 7.22% |
These funds have consistently performed in line with their objective of capturing price differences in the market while protecting capital.
How to Choose the Best Arbitrage Funds
Selecting the best arbitrage fund involves more than just checking past returns. Here are a few key factors to consider before investing:
- Expense Ratio: Since arbitrage strategies require active management, some funds charge a higher expense ratio. Lower costs can help you retain more of your returns, especially when the profit margins are already small.
- Exit Load and Lock-In: Many arbitrage mutual funds have an exit load if redeemed within 30 to 90 days. So, only consider them if you can remain invested for at least 3 months. Avoid these funds if you expect to withdraw the money quickly.
- Fund Size and Liquidity: Opt for funds with a healthy asset base and consistent inflows. This improves liquidity and ensures smoother trade execution for arbitrage opportunities.
- Consistency of Returns: Check how the fund has performed in different market conditions. While returns will not be high, consistency matters more than peak performance in arbitrage funds.
- Tax Treatment: Arbitrage funds are taxed like equity funds, making them more tax-efficient than debt funds, especially for short-term investments.
Taxation on Arbitrage Funds
The tax structure for arbitrage mutual funds is as follows:
- Short-Term Capital Gains (STCG): If you redeem your units within 12 months, the gains are taxed at 15%, regardless of your income tax slab.
- Long-Term Capital Gains (LTCG): If you hold the units for more than 12 months, gains up to тВ╣1 lakh per financial year are tax-free. Gains above тВ╣1 lakh are taxed at 10%, with no indexation benefit.
This structure is the same as equity mutual funds, giving arbitrage funds a clear edge over traditional debt investments regarding post-tax returns.
Difference from Debt Fund Taxation
Debt mutual funds, on the other hand, are taxed differently:
- Gains (regardless of holding period) are added to your total income and taxed as per your income tax slab rate.
- This can result in higher taxes, especially if you fall in the 30% bracket.
So, for shortтАФto medium-term investors looking to reduce tax liability while maintaining low risk, arbitrage mutual funds offer better post-tax returns than debt funds.
Conclusion
Arbitrage mutual funds are a smart choice for conservative investors looking to park funds for the short term while earning better post-tax returns than traditional savings or liquid funds. Their low-risk profile, equity-like tax treatment, and ability to deliver steady returns in volatile markets make them ideal for building an emergency fund or managing temporary surpluses.
If you want to invest in the best arbitrage funds without the hassle, the Appreciate app helps you get started in just a few taps. From tfund comparisons and transparent fee insights to simple investing and tracking tools, Appreciate is designed to make mutual fund investing easy, reliable, and goal-oriented. Download the app now!
FAQs
What is an arbitrage fund in mutual funds?
An arbitrage fund is a type of mutual fund that aims to generate low-risk returns by taking advantage of short-term price differences in the market. The fund manager simultaneously buys and sells the same stock in different markets or segments to capture small, risk-free profits.
How safe is investing in arbitrage funds?
Arbitrage mutual funds are considered relatively low-risk compared to pure equity funds. Since trades are executed simultaneously to lock in price differences, the exposure to market volatility is minimal. However, returns depend on the availability of arbitrage opportunities and may be modest.
Are arbitrage funds good for short-term investments?
Arbitrage funds are suitable for shortтАФto medium-term investments, typically 3 to 6 months. They are often used to park surplus funds while aiming for better post-tax returns than savings accounts or liquid funds.
What are the best arbitrage funds in India?
Some of the best arbitrage funds in India are chosen based on consistent returns, low expense ratios, and strong fund management. While returns are usually similar across the category, top-performing names may vary each year. Platforms like Appreciate can help you compare and invest in arbitrage funds efficiently.
How are arbitrage funds taxed in India?
Arbitrage funds are taxed like equity mutual funds. HereтАЩs how:
- Short-term gains (if sold within 12 months) are taxed at 15%.
- Long-term gains (after 12 months) are tax-free up to тВ╣1 lakh per year, and gains above that are taxed at 10% without indexation.
Disclaimer: Investments in securities markets are subject to market risks. Read all the related documents carefully before investing. The securities quoted are exemplary and are not recommendatory.
