Arbitrage Funds Explained: How to Earn Returns While Keeping Taxes Lower

If you have surplus money sitting in a savings account or a fixed deposit and want a relatively stable investment option with better tax efficiency, arbitrage funds can be worth considering. These mutual funds aim to generate returns by taking advantage of price differences between the cash and futures markets while keeping market direction risk low.

Many investors confuse arbitrage funds with equity mutual funds because they invest in stocks. However, their strategy is different. Instead of depending on stock prices rising, arbitrage funds use hedged positions to lock in price differences, making their behaviour closer to low-risk investment products.

For investors in higher tax brackets looking for a short-to-medium-term investment option, arbitrage funds can provide an attractive alternative to traditional fixed deposits and debt funds.

What Is an Arbitrage Fund?

An arbitrage fund is a type of hybrid mutual fund that earns returns by exploiting price differences of the same asset in different markets. The fund manager simultaneously buys shares in the cash market and sells the same shares in the futures market when prices differ.

For example: Suppose a stock is trading at:

The fund buys the stock at ₹1,000 and sells futures at ₹1,010. When both prices come closer at expiry, the ₹10 difference becomes the potential return after deducting expenses and transaction costs.

Since the fund holds opposite positions, it does not depend heavily on whether the stock market moves up or down.

How Do Arbitrage Funds Work?

The strategy behind arbitrage funds is based on market inefficiencies. A fund manager identifies price differences between:

• Spot market (where stocks are bought and sold immediately)
• Futures market (where contracts are settled at a future date)

The fund creates a hedged position:

Buy stock + Sell futures = Market-neutral strategy

This reduces direct exposure to stock market movements. Apart from arbitrage opportunities, a small portion of the portfolio may be invested in short-term debt and money-market instruments to generate additional income.

Arbitrage Fund Returns: How Much Can You Expect?

Unlike fixed deposits, arbitrage fund returns are not guaranteed. They depend on factors such as:

• Market volatility
• Futures market spreads
• Interest rate conditions
• Fund expenses

Historically, arbitrage funds have generally delivered returns in the range of around 6%–7.5% annually, although actual performance changes with market conditions. When markets are volatile, price differences between cash and futures markets can increase, creating more opportunities for arbitrage strategies. During periods of low volatility, returns may moderate.

Arbitrage Fund Taxation in India

One of the biggest advantages of arbitrage funds is their equity-oriented taxation. Although these funds behave like low-risk products, they qualify as equity funds because they maintain the required equity exposure. Current taxation rules:

This can make arbitrage funds more tax-efficient compared with traditional debt funds. For example, an investor in the 30% income tax bracket may find arbitrage funds more attractive than debt instruments where returns are taxed according to the applicable slab rate.

Arbitrage Fund vs Fixed Deposit (FD)

Many investors compare arbitrage funds with fixed deposits because both are considered suitable for conservative investors.

For investors in higher tax brackets, arbitrage funds may offer better post-tax efficiency compared with FDs. However, investors who need guaranteed returns may still prefer fixed deposits.

Arbitrage Fund vs Debt Fund

The better choice depends on your tax bracket, investment period, and risk preference.

What Should Investors Check?

Instead of selecting a fund only based on past returns, investors should evaluate:

• Consistency of returns
• Expense ratio
• Fund size and liquidity
• Portfolio transparency
• Fund manager experience
• Tracking performance against arbitrage benchmarks

A good arbitrage fund should maintain consistent performance rather than chasing short-term high returns.

Who Should Invest in Arbitrage Funds?

Arbitrage funds may be suitable for:

• Investors looking to park surplus money for 6–24 months
• High-income taxpayers seeking tax-efficient options
• Investors who want lower volatility compared with equity funds
• People waiting to invest in equity markets later.

They may not be suitable for:

• Investors looking for guaranteed returns
• Long-term wealth creation goals
• Very short-term parking needs of only a few weeks.
  
  

Advantages of Arbitrage Funds

Arbitrage funds offer several benefits:

• Lower volatility compared with equity mutual funds
• Equity taxation benefits
• Better liquidity compared with many fixed-income products
• Suitable for short-to-medium-term financial goals
• Useful alternative to savings accounts and fixed deposits for some investors.
  
  

Disadvantages and Risks of Arbitrage Funds

Despite their low-risk nature, arbitrage funds are not completely risk-free.

Important points to remember:

• Returns are not guaranteed
• Arbitrage opportunities can reduce during low market volatility
• Expense ratios impact final returns
• Short holding periods may be affected by exit loads
• Tax rules can change in the future

Investors should always match the investment option with their financial goals and time horizon.

Top 5 Arbitrage Funds in India – 2026

1. Invesco India Arbitrage Fund — 1Y ~6.9%, 3Y ~7.5% p.a., 5Y ~7.1% p.a.; strong long-term consistency. 
2. Kotak Arbitrage Fund — 1Y ~6.9%, 3Y ~7.8%, 5Y ~6.7%; very large AUM and established track record.
3. ICICI Prudential Arbitrage Fund — 1Y ~6.6%, 3Y ~7.3%, 5Y ~6.8%; large ₹35,000+ crore AUM. 
4. Nippon India Arbitrage Fund — 1Y ~6.7%, 3Y ~7.3%, 5Y ~6.8%; another established large-AUM option. 
5. HDFC Arbitrage Fund — 1Y around 6.6%, 3Y around 7.3%; HDFC reports ₹25,509 crore AUM as of Aug 2026 and describes the strategy as market-neutral. 
   
   

Are Arbitrage Funds Safe?

Arbitrage funds are considered among the lower-risk mutual fund categories because their buying and selling strategy reduces market direction risk. However, they are not the same as bank deposits.

The risks include:

• Execution risk
• Liquidity risk
• Lower returns during unfavourable market conditions.

Investors should understand that “low risk” does not mean “zero risk.”

Arbitrage Funds for Short-Term Investment: Are They a Good Choice?

For investors with a six-month to two-year horizon, arbitrage funds can be a practical option. They can work well for:

• Parking bonus money
• Keeping funds before a major purchase
• Temporary allocation before entering equity markets
• Tax-efficient short-term investing

For long-term goals like retirement planning or wealth creation, equity mutual funds may provide better growth potential.

Conclusion

Arbitrage funds provide a unique combination of low volatility, equity taxation benefits, and short-term investment potential. They can be a useful option for investors who want an alternative to fixed deposits or traditional debt products while avoiding the higher volatility of equity funds.

However, they should not be treated as guaranteed-return products. Before investing, consider your tax situation, investment duration, and financial goals. Used correctly, arbitrage funds can become an efficient tool for managing surplus money while improving post-tax returns.

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is only for educational purposes. Always discuss with your SEBI-registered financial advisor for investment-related decisions.