Arbitrage Fund

Where do you park surplus cash for a few months when fixed deposits feel tax-inefficient and liquid funds are now taxed at your slab rate? For many investors in higher brackets, the answer increasingly is the humble arbitrage fund.

How it makes money

An arbitrage fund exploits the small, recurring price difference between a stock in the cash market and its futures contract. The fund buys the share in the cash segment and simultaneously sells the corresponding future at a higher price, locking in the spread. As expiry nears, the two prices converge and the gap is realised as profit.

Because every long position is hedged with a matching short, the fund carries little directional market risk. It is not chasing whether the market goes up or down; it is harvesting the spread. Returns are therefore typically modest and FD-like, with occasional minor dips when spreads narrow.

The tax trick that makes it shine

Here is the real attraction. To qualify, an arbitrage fund keeps at least 65% of its corpus in equity and equity-related instruments (the hedged positions count), so SEBI classifies it as a hybrid scheme that is taxed as an equity fund.

That matters enormously after the 2023 changes, when many debt funds and bank FD interest moved to slab-rate taxation. Equity taxation, with its lower long-term rate and favourable short-term treatment, can leave a top-bracket investor materially better off on a post-tax basis, even if pre-tax returns are similar to a liquid fund.

Where it fits

Arbitrage funds suit investors with a horizon of roughly six months to a couple of years who want low volatility and tax efficiency, not high growth. Unsurprisingly, their assets under management in India have surged as savers chase post-tax efficiency. They are not risk-free: spreads can compress in dull markets, denting short-term returns.

Takeaway: if you're in the 30% bracket and parking money for several months to two years, run the post-tax maths between an arbitrage fund and a liquid fund. The pre-tax returns may look alike, but the equity tax treatment is often what tips the verdict in the arbitrage fund's favour.