Arbitrage funds are mutual funds that aim to generate relatively low-risk returns by taking advantage of price differences for the same security across different markets. They primarily use the difference between a security’s cash (spot) price and its futures price. Because these funds typically hold an equivalent long position in the cash market and a short position in the futures market, their exposure to the stock’s overall price movement is relatively limited.

This makes arbitrage funds less volatile than equity funds, although they are not completely risk-free. Transaction costs, taxes, liquidity, market conditions, and periods when suitable arbitrage opportunities are scarce can affect returns.

In India, arbitrage mutual funds are classified as equity-oriented funds and generally maintain at least 65% of their assets in equities or equity-related instruments. This can give them a tax advantage compared to debt-oriented investments, although the applicable tax treatment depends on the current tax rules and the investor’s circumstances.

Arbitrage mutual funds are suitable for:

• Conservative investors: Suitable for people who want exposure to equity markets but prefer lower volatility than traditional equity funds.
• Short-to-medium term investors: They can be considered by investors looking to park money for a few months to a couple of years.
• Investors seeking relatively stable returns: Arbitrage funds aim to earn from price differences rather than relying mainly on stock prices rising, which can make returns more predictable in suitable market conditions.
• Investors in higher tax brackets: Since arbitrage funds are treated as equity-oriented funds for taxation in India, they may be more tax-efficient than some debt instruments, depending on the investor’s holding period and applicable tax rules.
• Investors looking for short-term deposits: They may be worth considering when an investor wants potentially better returns while accepting some degree of market risk.
• Investors who do not need guaranteed income: Arbitrage funds do not promise a fixed interest rate or return, so they may not suit someone who needs certainty about how much money they will receive.

Arbitrage mutual funds aim to earn returns from price differences between cash and futures markets. The fund manager buys a security in the cash market and simultaneously sells the same security through a futures contract. Because the positions move in opposite directions, the fund reduces its exposure to the security’s overall price movement and focuses on capturing the price difference.

For example, suppose a stock is trading at ₹1000 in the cash market, while its futures contract is available at ₹1025. An arbitrage fund can buy the stock at ₹1000 and simultaneously sell the futures contract at ₹1025. While the futures contract expires, the two prices generally converge, allowing the fund to capture the ₹25 difference before costs and expenses.

At the end of the month, suppose the stock price rises to ₹1050. The fund’s cash market investment gains ₹50. However, its futures position loses ₹25 because it agreed to sell at ₹1025. The combined gain is therefore ₹25, before transaction costs and other expenses.

If the stock instead falls to ₹980, the cash position loses ₹20, while the futures position gains ₹45. The net gain is again approximately ₹25.

This example shows how the best arbitrage funds try to profit from the price gap rather than predicting whether the stock will rise or fall. However, actual returns can vary because of transaction costs, taxes, liquidity, and changing arbitrage opportunities.

Arbitrage mutual funds can be broadly understood based on the type of price differences they seek to benefit from. The arbitrage opportunities discussed below are broad, global classifications and are not necessarily strategies used in Indian markets.

• Pure and Market Arbitrage: This involves taking advantage of price differences for the same or similar assets across different markets or exchanges. For example, an investor may buy a stock on one exchange at a lower price and sell it on another at a higher price. It can also include cross-border and triangular arbitrage in currency markets.
• Corporate or Event-driven Arbitrage: These strategies focus on opportunities created by corporate events such as mergers, acquisitions, restructurings, or liquidations. Merger arbitrage, for instance, attempts to profit from the difference between a company’s current share price and the expected acquisition price.
• Quantitative Arbitrage: This uses mathematical models, historical data and algorithms to identify temporary pricing differences. Statistical arbitrage and pairs trading are examples where investors take positions in related assets that have temporarily moved away from their usual price relationship.
• Fixed-income and Derivative Arbitrage: These strategies focus on price differences involving bonds, commodities, interest rates, and derivatives. Cash-and-carry arbitrage involves buying an asset in the spot market while selling its futures contract, aiming to benefit from the difference in prices.
• Everyday and Retail Arbitrage: Arbitrage can also occur outside financial markets. Retail arbitrage involves buying products at a lower price from one seller and reselling them at a higher price elsewhere. Other examples include dividend arbitrage and futures arbitrage.

The best arbitrage mutual funds come with several benefits:

• Lower volatility: Arbitrage funds simultaneously buy and sell securities, creating hedged positions. This reduces their exposure to movements in the underlying security’s price. Simultaneous transactions can largely neutralise price volatility risk.
• Potentially suitable for conservative investors: These funds may suit investors with a lower risk appetite who want to invest for the short term. A holding period of more than three months may work better than a very short one.
• Potential to benefit from market volatility: Arbitrage opportunities can become more available when markets are volatile. These tend to be lower-risk investments that can benefit from unstable market conditions.
• Equity-oriented taxation: Arbitrage funds are equity-oriented hybrid funds, with at least 65% of the portfolio in equities and equity-related products. Therefore, they may receive equity-fund tax treatment, thereby giving them a risk-return profile similar to short-term debt funds while receiving equity taxation.
• Professional management: Investors do not need to identify and execute arbitrage opportunities themselves. The fund manager monitors markets and carries out the required transactions.

Although arbitrage funds are generally considered low risk, they are not completely risk-free.

• Limited arbitrage opportunities: Arbitrage funds depend on price differences between markets. Opportunities for arbitrage are more prevalent during turbulent markets and limited during tranquil markets. When markets are calm or trading within a narrow range, attractive opportunities can become sparse. This can reduce the fund’s ability to generate returns.
• Execution risk: The expected price difference may change before the fund can complete both sides of the transaction. This can reduce expected profit or even result in a loss.
• Credit risk: Arbitrage funds may invest part of their portfolio in debt and money-market instruments. If an issuer experiences financial difficulties or defaults, it can affect the fund’s returns.
• Liquidity risk: Some securities may not have enough buyers or sellers when the fund needs to trade. This can make it difficult to execute transactions at the expected price.
• Transaction costs: Arbitrage opportunities are often relatively small. Frequent buying and selling can increase brokerage, taxes, and other transaction costs, reducing the returns investors actually earn.
• No guaranteed returns: Arbitrage funds are not risk-free or guaranteed-return investments. Their performance depends on the availability of suitable opportunities and the fund manager’s ability to successfully capture them.

• Choose the fund carefully: Compare arbitrage funds based on historical performance, expense ratio, assets under management, and consistency of returns. A well-managed fund may be better positioned to identify and execute arbitrage opportunities.
• Check the portfolio: Review the fund’s equity and debt holdings. Pay attention to the quality of its debt instruments, as the debt component can expose the fund to credit risk.
• Look at the hedging strategy: Check whether the fund maintains adequately hedged equity positions. Equity hedging helps reduce the impact of market movements on the portfolio.
• Consider the investment period: Avoid treating arbitrage funds as a substitute for a savings account or very short cash holding. Giving the investment sufficient time can help the fund benefit from available arbitrage opportunities and reduce the impact of short-term fluctuations.
• Compare expense ratios: Arbitrage opportunities can involve frequent transactions and relatively small price differences. Higher expenses can therefore reduce the returns investors ultimately receive. Comparing expense ratios can help control this risk.
• Understand market conditions: Arbitrage opportunities may be more readily available during periods of higher market volatility and less available when markets are calm. Investors should therefore avoid assuming the past returns will continue consistently.
• Diversify: Do not depend entirely on one fund for short-term financial needs. Maintaining a diversified portfolio can help reduce the impact of poor performance from a single investment.

Along with arbitrage mutual funds, we can compare three other categories: equity funds, debt funds, and liquid funds.

When selecting arbitrage mutual funds to invest in, consider the following:

• Set your investment goal: Decide why you want to invest and how long you plan to stay invested. Arbitrage funds are generally more suitable for short-term investments.
• Choose a fund: Compare arbitrage funds based on factors such as past performance, expense ratio, assets under management, and return consistency.
• Check the fund’s portfolio: Look at the fund’s equity, derivatives, and debt holdings. Make sure you understand how the fund manages its positions and risks.
• Start small: Start with as manageable an amount as you can invest regularly. Even as little as a ₹100 SIP per week is a good starting point. Over time, you can step up your SIP after you’ve built the investing habit.

Investing in arbitrage funds through Millions involves a few simple steps:

• Download the Millions app from the Google Play Store or the iOS App Store.
• Create a free account by providing the required details.
• Complete the KYC process and activate your account.
• Browse the curated mutual funds and filter them according to your investment needs.
• Choose an arbitrage fund that aligns with your financial goals and investment strategy.
• For SIP investments, choose a suitable frequency such as daily, weekly, or monthly.
• Enter your investment amount, select your preferred SIP date, and complete the payment to begin your investment journey.