Arbitrage funds — equity tax treatment for debt-like returns

Arbitrage funds occupy a unique tax niche. They invest in equity stocks and simultaneously sell futures of the same stocks, locking in the cash-futures price difference (which is essentially the cost of carrying the long position to the futures expiry). The returns are debt-like — typically 5-7% — but because at least 65% of the portfolio is in equity, the fund qualifies as equity-oriented for tax. The combination produces meaningfully higher post-tax returns than debt funds for high-bracket investors.

The arbitrage strategy

Stock futures typically trade at a slight premium to the cash price — reflecting the "cost of carry" (the implied interest on holding the stock through the futures expiry). The arbitrage:

1. Buy stock X at cash price ₹100.
2. Simultaneously sell the futures contract for X at ₹101.
3. Hold both until futures expiry, when cash and futures prices converge.
4. The trade locks in ₹1 profit per share regardless of subsequent price movement.

The fund executes this systematically across many stocks, collecting the implied carry yield.

Why the spread exists

The cash-futures spread reflects:

• Cost of carry: the interest a buyer would pay to finance the stock purchase until futures expiry. Larger when interest rates are higher.
• Dividends: if a stock is expected to pay dividend before expiry, the futures price is adjusted downward (the futures buyer doesn't receive the dividend).
• Demand-supply for the futures: heavy short interest can push futures prices below cash, reducing or eliminating the arbitrage.

What drives arbitrage returns

Higher interest rates expand the cash-futures spread, increasing arbitrage returns. Some recent year ranges:

• Low-rate periods (2020-2021): 4-5% net return.
• Moderate rate periods (typical): 5-6%.
• High-rate periods (2022-2023): 6-7%.

The tax advantage

Because arbitrage funds hold ≥ 65% in equity:

• Qualify as equity-oriented for tax.
• STCG (held ≤ 12 months): 20%.
• LTCG (held > 12 months): 12.5% above the ₹1.25 lakh annual exemption.

Compare to debt fund post-2023 tax:

• All gains taxed at slab rate, potentially 30% for high-bracket investors.

For a 30%-bracket investor holding an arbitrage fund > 12 months:

• Pre-tax return: ~6%.
• Post-tax: ~5.25% (assuming gains within annual exemption).
• Equivalent post-tax return from a debt fund at 6.5% pre-tax: ~4.55%.

The arbitrage fund yields ~70 bps more post-tax — meaningful over the long term.

Risk profile

• Interest rate risk: minimal. The strategy is market-neutral on cash-futures spread.
• Stock price risk: minimal. The cash and futures positions hedge each other.
• Counterparty / clearing risk: low. Trades clear through stock exchange.
• Liquidity risk: some — during volatile periods, settlement issues are possible.
• Carrying cost risk: if the cash-futures spread compresses (low-rate environments), arbitrage returns suffer.

When arbitrage funds underperform

Two situations:

Low interest rate environments

When the carry cost (interest rate proxy) is low, the cash-futures spread is narrow, and arbitrage returns drop. During 2020-21, some arbitrage funds delivered 3-4% returns vs liquid fund 4-5%.

High volatility / settlement stress

During major market events (March 2020, large IPO settlements), the arbitrage execution can break down. Future prices may temporarily deviate from rational arbitrage levels. The fund's positions can show short-term losses (though these typically resolve at expiry).

Where arbitrage funds excel

Tax-efficient liquidity

For high-bracket investors holding ₹10 lakh+ in cash equivalents, arbitrage funds deliver meaningfully better post-tax returns than debt fund equivalents.

Bridge / parking

Funds awaiting deployment into equity — months 6-18 of an STP or bonus parking — benefit from arbitrage's better tax treatment vs liquid alternatives.

Emergency fund second layer

Months 3-6 of an emergency fund. Higher post-tax return than equivalent debt or savings alternatives.

Conservative income for retirees

Low-volatility income with equity-fund tax treatment. SWP from arbitrage delivers tax-efficient regular income.

Where they don't excel

• Capital appreciation: no equity growth — returns track money-market yields.
• Same-day or T+1 access: equity fund redemption settles T+2 typically.
• Very low rate periods: the strategy struggles when spreads compress.

Cost structure

Arbitrage funds have higher expense ratios than liquid funds because:

• Execution requires constant rebalancing.
• Futures rollover costs apply each expiry.
• Slightly higher operational complexity.

Typical TER: 0.30-0.60% for Direct plans. The expense ratio is paid from gross arbitrage profits; investors see net returns after this.

Cut-off times

Standard equity fund cut-offs apply:

• Purchase by 3:00 PM: same-day NAV.
• Redemption by 3:00 PM: same-day NAV; funds available T+2.

The market-neutral promise

Arbitrage funds market themselves as "market-neutral" — their returns don't depend on whether equity markets go up or down. This is approximately true:

• Even in major equity drawdowns (2020, 2022), arbitrage funds typically delivered positive returns.
• The cash-futures spread mechanism is independent of equity direction.

This characteristic — positive returns regardless of equity direction — makes them useful in portfolios as a "stable component" while equity provides growth.

The size question

Arbitrage fund AUM scaling has limits:

• The total arbitrage opportunity in Indian markets is bounded by daily futures volumes.
• If too much capital chases the strategy, spreads narrow and returns drop.

This is why some arbitrage funds have soft-closed during periods of heavy inflow.

Comparing arbitrage funds

Differences between arbitrage funds are usually small. Look for:

• Long track record of stable returns (5+ years).
• Low TER (Direct plan, larger AUM).
• Consistent performance during both high-rate and low-rate periods.
• AMC reputation for trading execution.

Holding period planning

For tax efficiency, hold arbitrage fund units > 12 months to qualify for LTCG (12.5% above ₹1.25 lakh exemption). For shorter holdings, STCG at 20% applies. Plan deployments and redemptions to cross the 12-month threshold where possible.

The corporate fixed-income alternative

For corporate treasuries holding large idle cash balances, arbitrage funds offer the same tax-favored treatment as for individuals. The post-tax yield advantage compounds significantly at scale.