Mutual Funds, Minus the Marketing · Part 17 of 30
Arbitrage funds: an equity fund that behaves like a debt fund
A strange-looking fund
An arbitrage fund is, by the rules of SEBI (the Securities and Exchange Board of India), a hybrid fund that keeps at least 65% of its assets in equity and equity-related instruments and “follows an arbitrage strategy” (paragraph 3.8.3 of SEBI’s Master Circular for Mutual Funds, 20 March 2026). It owns a lot of shares. And yet its NAV (net asset value, the per-unit value of the fund) moves like a debt fund’s: in the hybrid funds post it was the only fund that rose in 2008, early 2020 and early 2026.
The trick is that almost every share it buys, it also sells in the futures market at the same time. The two positions cancel each other’s price risk. What is left is a small, fairly predictable gap between the two prices — and that gap is what the fund earns.
The formula
A stock future is a contract to buy or sell the share on a fixed date (the monthly expiry) at a price agreed today. It usually trades a little above the share’s cash-market price, because whoever buys the future instead of the share gets the same exposure without paying the full price up front. That premium is roughly the interest cost of holding the share until expiry:
Future price ≈ Cash price × (1 + r × days/365) − expected dividends
Arbitrage trade: buy the share at the cash price S,
sell the future at F, hold both until expiry.
Locked-in gain = F − S (whatever the share does in between)
Return = (F − S) / S
Annualised ≈ (F − S) / S × 365 / days
On expiry day the future settles at the cash price, so the two legs converge. If the share has risen, the stock gains and the future loses the same amount; if it has fallen, the reverse. Either way, the fund keeps F − S, less trading costs.
Worked example 1: one trade
A hypothetical share, not a real company:
| Item | |
|---|---|
| Cash-market price | ₹1,000 |
| Future expiring in 30 days | ₹1,006 |
| Spread locked in | ₹6 per share |
| Return over 30 days | 0.6% |
| Annualised (× 365 / 30) | about 7.3% |
Suppose on expiry the share closes at ₹900. The fund loses ₹100 on the share and gains ₹106 on the short future, for a net gain of ₹6. At ₹1,100 it gains ₹100 on the share and loses ₹94 on the future, for the same net gain of ₹6. The market’s direction has dropped out of the answer.
Then do it again next month, across dozens of stocks, and park the rest in short-term debt to meet margin calls. That’s the fund.
Worked example 2: seven and a bit years of a real one
UTI Arbitrage Fund (regular plan, growth; AMFI scheme code 104075; AMFI is the Association of Mutual Funds in India) against the UTI Overnight Fund that the debt funds post used, from 3 May 2018 (when the overnight scheme took on its present mandate) to 31 March 2026. Source: AMFI NAV history via mfapi.in. Historical data, for illustration only. This post takes no view on either fund; they’re here because they have long histories from one fund house. Both columns are pre-tax NAV returns — and the two are taxed differently, which the last section covers.
| Item | Arbitrage fund | Overnight fund |
|---|---|---|
| Annualised return | 5.74% | 5.21% |
| Annualised volatility | 0.98% | 0.12% |
| Days the NAV fell | 33.6% | 0% |
| Worst 1-year return | 3.1% | 2.95% |
| Median 1-year return | 6.22% | 5.7% |
| Best 1-year return | 8.15% | 6.81% |
- The returns sit close together. Across 1,559 one-year windows ending on each day both funds published a NAV, the arbitrage fund was ahead in 85.8% of them, by a median of 0.74 percentage points. That’s the order of gap you’d expect from two ways of earning roughly the short-term interest rate.
- But it isn’t a straight line. The arbitrage fund’s NAV fell on 33.6% of days — about one in three. The overnight fund’s never fell. The fund marks both legs to market every day, and the gap between the cash and futures price wobbles day to day as traders’ demand shifts. A bad day was small — the worst was −0.38% on 1 June 2020 — but it happens often.
- Those daily wobbles wash out by expiry. Over its whole AMFI history from July 2006, only 4 of 236 calendar months ended lower, and the worst month was −0.07%. Its deepest fall from a peak was −0.7%, in March 2020, recovered by 31 March.
- The spread moves with interest rates. Calendar-year returns:
| Year | Arbitrage fund | Overnight fund |
|---|---|---|
| 2019 | 6.17% | 5.63% |
| 2020 | 4.38% | 3.36% |
| 2021 | 3.86% | 3.13% |
| 2022 | 4.04% | 4.63% |
| 2023 | 7.15% | 6.66% |
| 2024 | 7.73% | 6.67% |
| 2025 | 6.54% | 5.77% |
Both dipped in 2020–22 when rates were low and rose again as rates climbed — the cost-of-carry formula at work. In 2022 the arbitrage fund earned less than the overnight fund. An arbitrage fund is not a way to beat short-term rates; it’s another way of earning something close to them.
🧒 Explain it like I'm 10 (optional — skip if this is already clear)
Your friend will buy your cricket bat from you next month for ₹1,006, no matter what. Today, a shop sells the same bat for ₹1,000.
So you buy the bat for ₹1,000 and shake hands with your friend on ₹1,006. Next month the bat might be worth ₹900 or ₹1,100 in the shop — you don’t care. You’ve already agreed to sell it for ₹1,006. You made ₹6 for holding a bat for a month.
That’s all an arbitrage fund does, with shares instead of bats, over and over.
Why it’s taxed as equity
This is a big part of the category’s appeal. For tax purposes, an equity-oriented fund is one where “a minimum of 65% of the total proceeds of such fund is invested in the equity shares of domestic companies listed on a recognised stock exchange” (section 198(8) of the Income-tax Act, 2025, which applies from 1 April 2026). An arbitrage fund does hold those shares, in the cash market. The test counts the shares; it doesn’t subtract the short futures that hedge them. So a fund whose returns look like a debt fund’s gets equity-fund tax treatment, which can be lighter than the slab-rate treatment of debt-fund gains.
The rates and holding periods are in the tax series (the equity funds post), which starts later. This is also why the comparison table above is pre-tax only: after tax the gap between the two can be much wider than 0.74 percentage points, in either fund’s favour depending on your slab and holding period. Check the current rules for your own case.
Common mistakes
- Treating it as risk-free because the market risk is hedged. The directional risk is gone; the rest isn’t. The fund still holds short-term debt (with its own credit and rate risk), still has daily NAV falls, and the spread itself can shrink to very little when few traders want leverage.
- Using it for money you need next week. Its NAV falls on about a third of days, and some arbitrage funds carry an exit load on redemptions within a short period. Over days, an overnight or liquid fund is the steadier tool.
- Comparing its return with a debt fund’s without adjusting for tax. The pre-tax numbers were within a percentage point of each other. The after-tax numbers are what you actually keep, and they depend on your slab.
- Reading “65% equity” as equity exposure. Almost all of that 65% is hedged. The fund’s net exposure to the stock market going up or down is close to zero.
Takeaway: An arbitrage fund buys shares and sells their futures at the same time, so it earns the small gap between the two prices rather than the market’s direction. It returned about what an overnight fund did before tax, with more daily wobble, and is taxed as equity because it owns the shares it has hedged.
This post is for educational purposes only and is not investment advice. Wealth Primer explains concepts, not recommendations — nothing here is a suggestion to buy, sell, or hold any specific security or fund. The author is not a SEBI-registered Research Analyst or Investment Adviser. Any prices or figures used as worked examples are historical and shown only to illustrate a calculation. Past performance does not indicate future results. Please do your own research or consult a registered adviser before making investment decisions. See the privacy & disclaimer policy for more.
Tax rules are described as at August 2026 and may have changed since. The author is not a tax professional, and this post is not tax advice. Confirm the current position, and how it applies to you, with a qualified tax professional before you act.