Arbitrage Fund — Equity-Tax Treatment on Near-Risk-Free Returns

Definition

An Arbitrage Fund is a SEBI-defined open-ended hybrid mutual fund scheme that generates returns by simultaneously buying a stock in the cash (spot) market and selling an equivalent futures contract, locking in the spread between the two prices. Because the positions are perfectly hedged (long cash, short futures on the same underlying), the fund carries near-zero directional market risk. The return profile resembles a liquid or short-duration debt fund, yet the fund qualifies for equity fund taxation — the key structural advantage.

Portfolio composition

• Minimum 65% in cash-futures arbitrage positions (SEBI mandated). This 65% floor is the basis for equity-tax treatment, as the fund's gross equity exposure (long cash leg) meets the statutory threshold.
• Remaining corpus (up to 35%) may be deployed in debt instruments, money-market securities, or short-duration bonds to earn incremental yield.
• Positions are rolled monthly on NSE/BSE futures settlement cycles. Roll cost (the cost of carrying the spread to next expiry) affects net returns and varies with market conditions — wider spreads during volatile or expiry weeks improve returns.
• No single-stock directional bets; the fund is structurally long-short. Beta to Nifty is close to 0.

Regulatory framework

SEBI (Mutual Funds) Regulations, 1996 and SEBI Categorisation Circular (October 2017 / December 2017) classify Arbitrage as a Hybrid — Arbitrage Fund. Minimum net equity (cash leg) ≥65% of total assets is required for equity tax eligibility. SEBI Circular SEBI/HO/IMD/DF3/CIR/P/2017/114 standardised the category: one scheme per AMC. SEBI also caps derivative exposure under Regulation 44 and requires AMCs to disclose roll spreads and portfolio turnover in monthly factsheets. AMFI guidelines require daily NAV disclosure and portfolio disclosure within 10 business days of each month-end.

Tax / cost treatment

Because gross equity exposure (cash leg) ≥65%, arbitrage funds are treated as equity funds for tax purposes:

• LTCG (held >12 months): 12.5% on gains above ₹1.25 lakh/year (Finance Act 2024 rate).
• STCG (held ≤12 months): 20% flat (post-Budget 2024 revision from 15%).
• Dividend option: TDS at 10% per §194K above ₹5,000/year.
• TER: typically 0.3–0.8% (lower than active equity; competitive vs. liquid funds net of tax).

For investors in the 30% tax slab, the 20% STCG on a 12-month arbitrage fund holding outperforms liquid-fund returns taxed at 30% slab — the typical pitch for HNI/NRI cash-parking.

Worked example

Nifty spot 22,000; Nifty futures (1-month) 22,150. Spread = 150 points = 0.68%. Annualised spread approximately 8.2%. The fund buys the Nifty basket in spot and sells futures. At expiry, futures converge to spot (say 22,300 both); the cash leg gains 300 points, futures leg loses 300 points — net P&L zero on position but the ₹150 spread locked at entry is captured. Portfolio-level annualised arbitrage yield in FY25 averaged 6.5–7.5% for most Arbitrage Fund NAVs. An HNI in the 30% bracket holding for 13 months pays 12.5% LTCG vs. ~30% on an equivalent liquid fund — net post-tax yield advantage ~1–1.5% p.a. in a 7% gross return environment.

See also

• Balanced Fund
• Multi-Asset Fund
• Liquid Fund
• Tax-Efficient Cash Parking (Pillar)
• NSE

Primary source

• SEBI Categorisation Circular (Oct 2017) — Arbitrage Fund definition
• Income Tax Portal — Equity MF taxation (LTCG/STCG rates)

Disclosure: MintByte is an AMFI-registered Mutual Fund Distributor (ARN-314872). Glossary content is for investor education only and does not constitute investment advice. Invest based on your risk profile and financial goals.