What Are Arbitrage Funds? Here’s How They Deliver Low-Risk Returns!

Imagine you're at Crawford Market in Mumbai, where mangoes are selling for ₹80 per kilo. Just a few kilometres away, in Bandra Market, the same mangoes are being sold for ₹100 per kilo. You spot the opportunity - buy at ₹80, sell at ₹100, and earn a neat profit of ₹20 per kilo, without growing or storing any mangoes.

That’s exactly how arbitrage funds work.

They take advantage of price differences between two markets - buying stocks in the cash (spot) market where the price is lower and simultaneously selling them in the futures market where the price is higher. The difference in price becomes their profit, typically with low risk.
Let’s understand this concept more clearly in the financial context.

Introduction to Arbitrage Funds
Arbitrage funds represent a specialized category within the Indian mutual fund universe that leverages market inefficiencies to deliver low-risk returns. They are Hybrid Funds with a predominant allocation toward equities but differ from traditional equity funds in that they do not aim to benefit from directional market movements. Instead, they use a market-neutral strategy by exploiting temporary price discrepancies between cash and derivatives markets. These funds aim to generate profits without taking unhedged exposure to equities, making them an appealing option for conservative investors seeking tax efficiency.

Portfolio Composition and Structure

SEBI mandates that arbitrage funds must invest at least 65% of their assets in equity and equity-related instruments to qualify for equity taxation. The remaining portion, typically around 15–35%, is allocated to short-term debt and money market instruments. This allocation not only helps stabilize the fund’s returns but also provides liquidity. The equity component is almost entirely hedged through futures, while the debt portion is managed conservatively to preserve capital.

Fund managers actively manage these portfolios, often churning trades frequently to capture fleeting arbitrage opportunities. As a result, arbitrage funds tend to have a higher portfolio turnover ratio and relatively higher expense ratios compared to debt or liquid funds. However, the benefits of the strategy and tax treatment often justify the costs for many investors.

How Arbitrage Funds Work

The core strategy of an arbitrage fund involves simultaneously buying a security in the spot (cash) market and selling it in the futures market where the price is typically higher due to cost of carry or market sentiment. For instance, if a stock is priced at ₹1,000 in the cash market and ₹1,020 in the futures market, the fund will purchase it in the spot market and sell the same in the futures market. When the futures contract expires, both positions are closed, and the fund captures the ₹20 spread as profit. Since both legs of the trade are executed at the same time, market volatility has minimal impact, and the fund essentially earns a risk-free profit from the arbitrage.

This strategy is repeated across multiple securities, and sometimes intraday or weekly arbitrage opportunities are also utilized. However, the success of this model is highly dependent on the availability of sufficient spreads and liquidity in both the cash and futures markets. During periods of low volatility or market stagnation, arbitrage opportunities may shrink, leading to subdued returns.

Risks and Limitations

While arbitrage funds are considered low-risk, they are not entirely risk-free. The primary risk is the unavailability of arbitrage opportunities, which can happen when markets are calm or highly efficient. In such situations, the fund’s return may largely depend on its debt allocation, which typically yields lower returns. Another consideration is the expense ratio, which can be higher due to frequent trading activity. Additionally, transaction costs such as Securities Transaction Tax (STT), brokerage fees, and GST can eat into the small margins generated through arbitrage.

There is also a minor credit risk and interest rate risk from the fund’s debt holdings, though most arbitrage funds stick to high-quality, short-duration instruments to manage this. Liquidity is generally good, but some funds impose exit loads if units are redeemed within 30 to 90 days, to discourage ultra-short holding periods.

Suitability for Investors

Arbitrage funds are best suited for conservative investors seeking a short-term investment avenue with low risk and favorable tax treatment. They serve as an ideal temporary parking option for surplus cash, especially for those in higher tax slabs. Investors planning to remain invested for at least three months, and preferably six to twelve months, are likely to benefit the most. For long-term capital growth or high returns, however, arbitrage funds may not be appropriate, as they are designed more for capital protection than wealth creation.

These funds are also useful in asset allocation strategies where stability and tax efficiency are desired. Corporate treasuries, HNIs, and retail investors alike can benefit from arbitrage funds as a substitute for liquid funds, especially when equity markets are volatile and arbitrage spreads are more pronounced.

Disclaimer: This article is for informational purposes only and not investment advice.