Arbitrage Mutual Funds: Meaning, How They Work, Benefits, Risks, and Taxation

In summary

Arbitrage funds seek to capture temporary price differences rather than depend primarily on the direction of the equity market.

• Arbitrage involves buying and selling related positions simultaneously.
• These funds must invest at least 65% in equity and equity-related instruments.
• Futures and cash-market price differences create arbitrage opportunities.
• Returns depend on available opportunities, costs, and market conditions.
• Equity-oriented tax treatment applies subject to applicable Income Tax rules.
• Arbitrage funds can still generate negative returns.

As of August 2026, SEBI reported 40 Arbitrage Fund schemes with approximately Rs. 3.57 lakh crore in assets under management.

Arbitrage mutual funds are open-ended hybrid schemes that follow an arbitrage strategy. Their objective is to identify price differences between related securities or positions in different markets and attempt to capture the difference.

A common example involves the cash and futures markets. If a stock trades at Rs. 100 in the cash market while its futures contract trades at Rs. 103, a fund may buy the stock and sell the corresponding futures position. If the positions converge as expected, the difference can contribute to the fund's return, after applicable costs.

Under SEBI's current framework, an Arbitrage Fund must invest at least 65% of total assets in equity and equity-related instruments.

Arbitrage funds are therefore a category of hybrid mutual funds, although their strategy differs significantly from conventional equity-debt allocation strategies.

The strategy depends on identifying a price difference between two related positions and taking offsetting positions to capture that difference.

Identifying an arbitrage opportunity

The fund manager looks for situations where the same or economically related security is priced differently across markets or instruments.

For example:

• A share trades at Rs. 1,000 in the cash market.
• Its futures contract trades at Rs. 1,020.
• The fund buys the share and sells the futures contract.
• If the positions converge, the Rs. 20 difference can contribute to the gross arbitrage return.

The actual result can differ because of transaction costs, taxes, financing costs, bid-ask spreads, execution timing, and changes in the market.

What happens when the positions converge?

The cash and futures positions are structured so that changes in the underlying share price are largely offset by the corresponding derivatives position. The fund's return therefore depends more on the pricing difference and how efficiently the trade is executed than on simply predicting whether the share price will rise or fall.

The fund manager's role is central to identifying and executing such opportunities. 

An arbitrage fund can have substantial equity holdings while using derivatives to hedge the corresponding market exposure.

This means its behaviour can differ from that of a conventional equity mutual fund. However, it would be inaccurate to describe arbitrage funds as risk-free or assume that hedging eliminates all investment risk.

The strategy can face execution risk, basis risk, counterparty-related considerations, liquidity constraints, and periods when attractive arbitrage opportunities are limited.

The SEBI Riskometer should also be considered when assessing a scheme. Its categories are Low, Low to Moderate, Moderate, Moderately High, High, and Very High. The Riskometer indicates scheme-level risk and does not guarantee a particular level of return or protection from losses.

Arbitrage funds can have certain characteristics that make them different from conventional equity funds.

Potentially lower sensitivity to market direction

Because the strategy uses offsetting positions, returns are not intended to depend primarily on whether the underlying equity market rises or falls.

This does not mean that the fund is immune to market movements. The effectiveness of the hedge and availability of opportunities affect the outcome.

Equity-oriented classification

The minimum 65% equity and equity-related allocation is relevant to the scheme's regulatory classification. It also matters for Income Tax treatment, subject to the applicable provisions and conditions.

Diversification across arbitrage opportunities

A fund can pursue opportunities across multiple securities and contracts. This can spread the strategy across several individual trades rather than depending on one position.

Potential use for short-to-medium investment horizons

Some investors consider arbitrage funds for relatively shorter holding periods. However, the appropriate horizon depends on the scheme, expected opportunity environment, costs, tax considerations, and the investor's objective.

They should not be treated as a substitute for a bank deposit or as a guaranteed-return product.

Arbitrage strategies reduce some forms of directional market exposure, but they do not remove investment risk.

Limited arbitrage opportunities

The price differences that create arbitrage opportunities can narrow or disappear. When spreads are small, the potential return after costs can also be limited.

Execution risk

The prices available when a fund attempts to establish or close positions can differ from expected prices. Trading costs, spreads, settlement, and timing can affect the realised result.

Basis risk

The cash and derivatives positions may not move in exactly the expected relationship. Changes in the futures-cash price relationship can affect the outcome.

Liquidity and counterparty considerations

Certain positions may become harder or more expensive to transact under stressed market conditions. Derivatives also involve counterparty and settlement considerations within the applicable market infrastructure.

Costs can reduce returns

Arbitrage trades can involve repeated transactions. Brokerage and other transaction-related expenses, fund expenses, and applicable taxes can reduce the return generated from price differences.

The expense ratio is therefore an important factor when comparing schemes.

Arbitrage funds meeting the applicable equity-oriented classification are generally taxed under the provisions applicable to equity-oriented mutual funds, subject to the prevailing Income Tax rules.

For transfers on or after 23 July 2024, the current framework provides:

• Short-term capital gains: 20% where the applicable Section 111A conditions are met.
• Long-term capital gains: 12.5% on the amount exceeding the applicable Rs. 1.25 lakh annual threshold under Section 112A, subject to the relevant conditions.

CBDT's current filing rules reflect the 20% rate for applicable short-term gains and 12.5% treatment for applicable long-term gains on transfers on or after 23 July 2024.

Both arbitrage and liquid mutual funds can be considered for relatively shorter investment horizons, but their underlying strategies are different.

Last updated: September 2026

Therefore, comparing the two only on recent returns can be misleading. Their risk drivers, tax treatment, and return-generation mechanisms are different.

You can read more about debt mutual funds.

Look beyond recent returns when assessing an arbitrage fund.

Examine the investment strategy

Review how the fund identifies arbitrage opportunities, its cash and derivatives exposure, and the circumstances in which it may adopt a defensive allocation.

Review the opportunity environment

Arbitrage spreads can vary with market conditions, liquidity, volatility, interest rates, and derivatives pricing. A period of narrow spreads can affect the return potential.

Check costs

Compare the expense ratio and other applicable costs. A strategy that captures small price differences can be particularly sensitive to transaction and operating expenses.

Consider the investment horizon

Match the holding period with your objective rather than assuming that an arbitrage fund is suitable simply because its volatility may be lower than that of some equity funds.

Review the scheme documents

The Scheme Information Document provides details about the investment objective, strategy, asset allocation, risks, expenses, and other terms. Review these details before investing.

Suppose an arbitrage fund identifies a share trading at Rs. 500 in the cash market while its one-month futures contract trades at Rs. 510.

The fund could buy the share for Rs. 500 and simultaneously sell the corresponding futures position at Rs. 510.

If the positions converge as expected, the gross price difference is Rs. 10 per share. However, Rs. 10 is not the fund's guaranteed profit. Brokerage, taxes, exchange charges, bid-ask spreads, financing costs, execution differences, and other expenses can reduce the realised return.

The example illustrates the mechanism rather than predicting the return of an actual arbitrage fund.

An arbitrage fund may be considered by an investor who understands its strategy and wants exposure to an equity-oriented mutual fund whose returns are primarily linked to arbitrage opportunities rather than outright equity-market direction.

It may be relevant when:

• You understand the strategy: You are comfortable with cash-market and derivatives-based arbitrage.
• You have a suitable time horizon: Your investment objective aligns with the scheme's risk and return characteristics.
• You accept variable returns: Arbitrage opportunities and their spreads are not constant.
• You understand the tax treatment: You have considered the applicable Income Tax provisions.
• You have reviewed the scheme: You have assessed its portfolio, strategy, costs, fund manager, and risk level.

The mutual funds section on the Bajaj Broking website provides access to 4,000+ mutual fund schemes across categories. The relevant scheme documents should be reviewed before selecting a fund.

NAV, or Net Asset Value, represents the value attributable to each unit of a mutual fund scheme after accounting for its assets and liabilities.

The NAV of an arbitrage fund reflects the value of its equity holdings, derivatives positions, cash, and other permitted investments, after applicable expenses and liabilities.

Arbitrage mutual funds use offsetting positions to seek gains from price differences between related securities or markets. Their minimum 65% allocation to equity and equity-related instruments is an important part of their regulatory classification and tax treatment.

The strategy can reduce dependence on broad market direction, but it does not eliminate risk or guarantee returns. Before investing, assess the fund's strategy, arbitrage opportunity environment, costs, portfolio, risk level, tax treatment, and investment horizon.

Last reviewed: September 2026

Mutual funds are subject to market risk. Please read the scheme-related documents carefully before investing.