Arbitrage Funds: What They Are and How They Generate Returns
Blog by Aliceblue News Desk
12 November 2026
8 minutes
A stock can trade at different prices in the cash market and the futures market at the same time. Arbitrage funds aim to earn returns from this price difference by taking offsetting positions, rather than relying mainly on the stock price rising.
Understanding how arbitrage funds generate returns starts with these two markets. The cash market lets investors buy shares, while futures are contracts linked to an underlying asset. Alice Blue’s guide to how futures contracts work in India provides useful background on their pricing and settlement.
Table of Contents
What Are Arbitrage Funds?
Arbitrage funds are mutual fund schemes that seek to profit from price differences between related securities or markets. A common strategy involves buying a stock in the cash market and simultaneously selling an equivalent quantity of its futures when the futures price is higher.
The difference between these prices is called the spread.
The opposing positions reduce exposure to the direction of the stock price. However, the fund’s actual returns still depend on available spreads, expenses and successful execution. Returns are not guaranteed.
How Do Arbitrage Funds Generate Returns?
The main mechanism is called cash-and-carry arbitrage.
1. Identify a Price Difference
Suppose a stock trades at ₹1,000 in the cash market, while its futures contract trades at ₹1,006.
The futures contract is trading at a ₹6 premium. The fund manager checks whether this difference offers a worthwhile opportunity after considering trading costs and other expenses.
2. Buy Shares and Sell Futures
The fund buys the stock at ₹1,000 and sells the corresponding futures at ₹1,006.
These positions work in opposite directions:
- If the stock rises, the cash holding gains while the short futures position loses.
- If the stock falls, the cash holding loses while the short futures position gains.
3. Capture the Spread as Prices Converge
At expiry, futures and cash prices converge. This allows the fund to realise the initial difference, subject to costs and execution.
The fund may also close both positions before expiry if the spread narrows sufficiently. It can then deploy the money into another suitable opportunity.
The important distinction is that the strategy seeks to earn the price gap. It does not require the stock to finish above its purchase price.
Arbitrage Fund Returns Explained With an Example
Assume a fund takes the following hypothetical position:
Transaction | Price | Quantity | Value |
Buy shares in the cash market | ₹1,000 | 1,000 shares | ₹10,00,000 |
Sell equivalent stock futures | ₹1,006 | 1,000 shares equivalent | ₹10,06,000 |
Initial gross spread | ₹6 per share | 1,000 | ₹6,000 |
Assume the quantities match the applicable futures lot size, with no dividends or corporate actions during the period.
Scenario A: The Stock Price Rises
At expiry, both prices converge at ₹1,050.
Position | Calculation | Gain or loss |
Cash shares | (₹1,050 − ₹1,000) × 1,000 | ₹50,000 |
Short futures | (₹1,006 − ₹1,050) × 1,000 | −₹44,000 |
Combined gross result | ₹50,000 − ₹44,000 | ₹6,000 |
Scenario B: The Stock Price Falls
At expiry, both prices converge at ₹950.
Position | Calculation | Gain or loss |
Cash shares | (₹950 − ₹1,000) × 1,000 | −₹50,000 |
Short futures | (₹1,006 − ₹950) × 1,000 | ₹56,000 |
Combined gross result | ₹56,000 − ₹50,000 | ₹6,000 |
The gross result is the same in both illustrations because the two positions offset the directional price movement.
This ₹6,000 is a hypothetical gross trading result, not the return an investor is promised. Transaction costs, scheme expenses, margin requirements and other portfolio holdings affect the fund’s actual return.
What Determines Arbitrage Fund Returns?
Available Spreads
A wider cash-futures spread can create a better gross opportunity. A narrow spread may leave little income after costs.
Once an opportunity ends, the fund must find another one. It cannot assume that the same spread will remain available for the next investment cycle.
Market Conditions and Trading Demand
Demand for futures, financing conditions and market liquidity influence the opportunities available.
Volatile markets may create price differences, but volatility alone does not guarantee higher arbitrage fund returns. The fund must be able to execute both sides at suitable prices.
Expenses
Arbitrage strategies involve repeated transactions. Trading costs and ongoing fund expenses reduce the amount investors ultimately receive.
When comparing schemes, use consistent cost measures. Alice Blue’s explanation of BER vs TER in mutual funds helps distinguish the components of mutual fund expenses.
Income From Permitted Cash and Debt Holdings
Alongside arbitrage positions, a scheme may hold permitted cash, collateral and fixed-income investments. Income from these holdings can contribute to returns.
To understand the distinction between owning shares and lending through debt instruments, read Alice Blue’s guide to debt securities vs equity securities. Check the scheme’s latest documents for its permitted allocation.
What Are the Benefits of Arbitrage Funds?
Lower Dependence on Stock Market Direction
Matched cash and futures positions can offset much of the impact of stock price movements. This makes the strategy different from an equity fund that holds shares primarily for appreciation.
Professional Execution
Fund managers handle opportunity selection, position matching, margins and settlement. Investors access the strategy through mutual fund units rather than managing each transaction themselves.
A Different Source of Portfolio Returns
Arbitrage returns depend mainly on spreads rather than company earnings growth alone. This can provide diversification from investments whose performance is driven by rising share prices.
What Are the Risks of Arbitrage Funds?
Arbitrage funds reduce directional equity exposure, but they remain market-linked investments.
Risk | What it means |
Narrow spreads | Available opportunities may generate little income after costs |
Execution risk | Both sides may not be completed at the expected prices |
Liquidity risk | Closing positions may become more expensive or difficult |
Short-term NAV fluctuations | Changes in spreads and valuations can affect daily unit prices |
Margin requirements | Futures positions require liquidity to meet settlement obligations |
A fund may also underperform alternatives when profitable arbitrage opportunities are limited.
Investors should therefore avoid treating an arbitrage fund as a fixed deposit or assuming that every short holding period will produce a positive return.
Arbitrage Funds vs Equity Funds vs Liquid Funds
Basis | Arbitrage funds | Equity funds | Liquid funds |
Main return source | Price spreads and income from permitted holdings | Changes in share prices and dividends | Income from short-term debt and money market instruments |
Directional equity exposure | Generally limited through hedging | Usually substantial | No equity focus |
Main purpose | Capture arbitrage opportunities | Seek long-term capital growth | Park short-term surplus |
Guaranteed returns | No | No | No |
What to compare | Spreads, expenses, exit load and portfolio | Strategy, valuation exposure and volatility | Portfolio quality, liquidity and expenses |
The right choice depends on when you need the money and which risks you can accept. These categories serve different purposes.
How Are Arbitrage Funds Taxed?
Arbitrage funds generally receive equity-oriented taxation when they satisfy the applicable domestic-equity conditions.
For qualifying investments, the broad capital gains treatment is:
Holding period | Tax treatment |
12 months or less | Short-term capital gains generally taxed at 20% |
More than 12 months | Long-term capital gains generally taxed at 12.5% above the aggregate annual ₹1.25 lakh exemption |
Applicable surcharge and cess are additional. The ₹1.25 lakh exemption applies across eligible gains, rather than separately to each fund.
Tax treatment can affect suitability, but it should be assessed alongside expected returns, costs and withdrawal needs.
Who Should Consider Arbitrage Funds?
Arbitrage funds may suit investors seeking limited directional equity exposure who can tolerate small fluctuations and hold beyond the scheme’s applicable exit-load period.
They may be less suitable for money needed immediately or where even a temporary decline would cause difficulty.
Before investing, check:
- The latest Riskometer and portfolio.
- Exit-load conditions and redemption timelines.
- Expenses for the chosen plan.
- Performance across different periods.
- How the investment fits your existing holdings.
Alice Blue’s guide to client risk profiling explains why willingness to take risk and financial capacity to absorb losses should be considered separately.
Conclusion
Arbitrage funds generate returns mainly by capturing price differences between cash and futures markets. Matched positions reduce dependence on whether share prices rise or fall.
Their appeal depends on the spreads available after costs, tax treatment and your investment horizon. Understand these factors before using an arbitrage fund to park surplus money.
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