Arbitrage funds are a type of mutual fund that earns money from tiny price differences happening in the market at the same time. Compared to many other equity funds, these funds usually keep risk relatively lower. So for people looking for something in between, like safety plus some growth, arbitrage funds often sound appealing.

What Are Arbitrage Funds and Why Do They Return Money?

Arbitrage funds rely on a strategy also called “arbitrage.” In simple terms, arbitrage means buying one asset and selling the same asset in different markets, simultaneously. The profit comes from the price gap, after all costs.

For instance, a fund might buy shares in the cash segment (the spot market) while also selling futures tied to the same shares. If the futures price and cash price differ by enough, the net difference (after expenses) becomes the fund’s gain.

Because the fund keeps both sides of the trade, the overall risk gets dampened. Usually, if one side takes a hit, the other side can offset it, so the overall movement is often less bumpy than a pure equity fund.

How Arbitrage Funds Are Typically Built

Most arbitrage funds, a category of mutual funds, don’t stay 100% invested in stocks. They usually keep a large portion in equities, while the remaining part is allocated to debt or money market instruments.

That debt portion helps in two ways: it adds stability and it supports liquidity. In practical terms this can make it easier for the fund to handle redemptions, meaning investors can exit without the fund needing to sell equity holdings at an inconvenient time, or during a falling phase.

So the blend of equity plus debt is why these funds are often seen as moderate in returns. They tend to do better than fixed deposits, but they generally don’t match the aggressive upside of high-risk equity strategies.

Common Arbitrage Approaches

Here are a few strategies these funds commonly use

1) Cash-Futures Arbitrage: This is the most popular one. The fund buys the stock in the cash market, and sells the related futures. The spread between cash and futures becomes the target profit. Since the positions are hedged, sudden market swings usually have a limited impact.

2) Merger Arbitrage: Some funds stare at companies that have merger or takeover plans. Usually the fund buys the shares of the firm that is expected to be absorbed, and then it assumes those shares will be sold off later, at a higher takeover price once everything is finalized. Of course the whole thing hinges on one detail, which is whether the deal really closes or not.  

3) Convertible Arbitrage: With this strategy, funds put money into convertible bonds. At the same time, they commonly hedge by short-selling the related stock. The idea is that the final results can come from the bond side plus whatever happens with the stock. So returns are not purely directional, and risk stays somewhat more manageable than if they were just betting one way.  

How the Returns Are Generated

Arbitrage funds earn money by grabbing small mismatches between prices across cash markets and derivative products. They do a lot of trading, so the small profits add up, and they repeat it over and over.  

They also collect interest on the debt portion, which gives a steadier, calmer component to the overall performance. In practice, investors might end up with a blend of hedged equity-linked outcomes, plus more consistent interest income.  

That being said, returns can look weaker when the market is calmer. When conditions are stable, the pricing gaps tend to compress, so there’s less spread available to collect. Risk is still lower, but it isn’t completely gone. Things like trade execution quality, shifts in interest rates and liquidity conditions can still nudge performance, even if less dramatically.

Tax Treatment

Arbitrage funds are taxed like equity funds only if at least 65% of the portfolio is invested in stocks. If that condition is met, then:

• Long-term capital gains (LTCG): taxed at 10% without indexation  
• Short-term capital gains (STCG): taxed at 15%

For the debt or money market portion, taxation follows the usual rules applicable to debt funds.

In many cases this tax setup can make arbitrage funds more efficient than fixed deposits, depending on the investor’s tax slab and overall situation.

Who Can Invest in Arbitrage Funds?

Arbitrage funds tend to match investors who can handle moderate risk. They may offer slightly better returns than fixed deposits or liquid funds, while still being less volatile than many pure equity funds.

They can also work as a parking place for surplus money temporarily. That said, if you’re focused on long-term growth, you may still prefer broader equity funds. Some investors who care more about stability might use arbitrage funds alongside fixed-income investments.

Conclusion

Arbitrage funds basically aim to strike a balance between safety and returns. They capitalize on the price differential between equity cash and derivatives to earn profits. The debt component helps to keep the scheme stable and reasonably liquid.

So the overall mix often leads to moderate returns with lower risk than typical equity-only funds.

If you’re exploring options, platforms such as Bajaj Broking can help you understand what arbitrage funds do and where they may fit in a diversified plan. With hedging, structured execution, and a blend of equity plus debt, arbitrage funds can remain a practical option for cautious investors who still want some equity exposure.

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