Whenever we have a little extra money sitting in our account, the easiest option seems to be to put it into an FD. We comfortably get an average interest rate of around 6%. That's how we usually think. But whatever interest rate we get gets taxed directly according to our income tax slab percentage rate. So the effective interest rate on that 6%, if you're in the 30% slab, comes down to around 4%. Similarly, for someone in the 20% slab, it comes down to less than 5%. But we have a much better, tax-efficient, low-risk option available, which is called arbitrage funds. We'll discuss in this post about arbitrage fund. We'll see how much better returns can be compared to an FD.
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| Arbitrage Fund Explained. Are Arbitrage Fund Better Than FD |
FD vs Arbitrage Funds: Interest Rate
Now, what exactly are arbitrage funds? How do they work? Before understanding that, let's first look at how much interest we're currently getting on an FD, and approximately how much return arbitrage funds are generating. Let's understand this with data. If we look at 2026 SBIFD rates, you can see here all the interest rates are available for us to see. The maximum interest rate for the general public is on a 23-year FD, which is 6.4%, and for senior citizens, on a 5-year FD, it's 7.05% interest. So if we look at this, we're seeing interest rates ranging from about 6 to 7%. On the other hand, if we look at arbitrage funds and what returns they've given over the past 11 years. So you can see here — the minimum has been around 4.5%, and the maximum has been 8.4%. So here too we can assume returns in the range of roughly 6.5 to 7%. In arbitrage funds, the money is technically invested in the stock market, but the risk becomes negligible there —meaning it's quite low, comparable to an FD. We'll now look at exactly what happens, because all the positions are hedged.
Arbitrage Funds vs Nifty Returns
Now,there's one more important thing to check here — whenever the Nifty 50, which represents the stock market, has gone negative, do these funds give positive returns? Because generally our fear about investing in the stock market is exactly this — that whenever the stock market goes down, our portfolio will go negative too. So here, you can see in 2015 the Nifty 50 had negative returns. Arbitrage funds had positive returns. And if we look at other cases where the Nifty 50 gave low returns — take 2016, for instance: 2.8% for Nifty versus 7.2%here; in 2018, 1.6% versus 6.7%; in 2022 we see 4.3% versus 5.4%. So these are cases where the Nifty gave negative or very low returns, and arbitrage funds gave much better returns in comparison. But of course, when the Nifty 50 gives good returns, like 29%, 14%, 14.5%, or even 24% in some years, arbitrage funds don't perform as well, because they're not taking on stock market risk.
How Arbitrage Funds Work?
Now let's understand how exactly an arbitrage fund works. We'll take the example of an Asian Paints stock and try to understand how arbitrage would work with it. This is not any kind of recommendation. It's an educational post. In fact, as of today this isn't even the actual stock price — it's purely for illustration. Let's say Asian Paints stock is trading in the cash market today at ₹2500, and its 1-month-forward futures contract is trading at ₹2512. So the fund manager tries to pocket this ₹12 gap. How does he do it? Let's understand. What will the arbitrage fund manager do? He'll buy this stock at ₹2500 — the price at which it's trading today in the cash market — he buys it. On the other hand, he sells the futures, which are trading at ₹2512 — meaning he shorts it today. He'll have to buy it back in a month later. That's how shorting works. So what's happening here? This ₹12 — this difference — we call it the spread. This is the difference that gets pocketed inside an arbitrage fund. So this ₹12 difference — how exactly does it end up in your pocket? Let's understand. Say one scenario is that the stock went from 2500 to 2600. Since we bought it at ₹2500 and now sold it at ₹2600, we made a profit of ₹100 on the cash position. But on the other hand, we had sold the future at ₹2512, and now we'll have to buy it back at ₹2600. That means we made a loss of ₹88. Net, 100 minus 88 comes to ₹12 of benefit. So ₹12 came into our pocket after 1 month. Now say the stock instead falls to ₹2400. What happens then? On the cash position, we now make a loss of ₹100, since we bought it at ₹2500 and sold it at ₹2400. On the other side, we make a profit on the futures — since we sold it at ₹2512, and now buy it back at ₹2400, that's a profit of ₹112. So in this case too, we get a net benefit of ₹12. Let's take one more, an in-between case. Say it becomes ₹2506. In that case what happens? We make a ₹6 profit in the cash market and a ₹6 profit on the futures. So again the net comes to ₹12. So the point is very simple — we're buying something at ₹2500 and selling its futures at ₹2512, so ₹12 net comes into our pocket no matter what.
Arbitrage Funds: Features
The strategy used inside an arbitrage fund is the cash-futures spread, which we've already discussed. The fund manager tries to capture the gap between the cash market and the futures market. The risk in this is low, just like an FD, because on one side we've already immediately locked in that ₹12. Returns of 6.8 to 7% have been seen here over the last 5 years' average for arbitrage funds. As for liquidity, it's also high here. Your money comes back on a T+2 basis. Meaning, 2 days after the day you sell your fund. With FDs, we could say liquidity is somewhat lower in comparison, because with an FD the money comes into your account immediately, within seconds, as of today. Taxation is the biggest benefit here. The tax that applies here is calculated the same way as equity mutual funds. Whatever returns you get from an FD are directly taxed according to your income tax slab, no matter whether you withdraw or not, and even if you withdraw a smaller amount, you'll still be taxed. But with equity mutual funds, tax only applies when you actually withdraw. So if you withdraw less, you get taxed less. If you withdraw more, you get taxed more. And the long-term capital gains tax here, after one year, is only 12.5%. And we also know that there's a ₹1.25 lakh exemption available. Every year you get this exemption on long-term capital gains, which also saves us a fair amount of tax. As for exit load, if you withdraw within 30 days, it's 0.25%. Whereas with an FD, say you've booked a 2-year FD and withdraw before that, your interest rate usually drops to less than 1%. So in that case, the effective exit penalty ends up being much higher there. As for the underlying holdings, we've already discussed that it trades in equities. It tries to capture opportunities across derivatives and debt markets — basically anything the market offers — and along with that,arbitrage funds also keep around 20-30% of their money in debt funds,where too we can expect returns of around 6 to 7%.
Also Read, 4 Low Risk Investment Alternatives to Fixed Deposit and Bank Savings
Who Should Invest In Arbitrage Funds?
So who should invest? Anyone who has taxable income. Especially if your tax slab is above 15%, it becomes very important for you to know about this fund. If you want to put money into a low-risk fund and you're specifically comparing it to an FD, this could be a good option for you. As for the time horizon, if it's anywhere from 6 months to 2-3 years, they should definitely consider arbitrage funds. If you're saving up money for an emergency fund, arbitrage funds can be a good option for you. And risk-averse investors who don't want to be subject to debt-fund style taxation but still want the tax efficiency of equity — that's the biggest benefit here — for such people too, arbitrage funds can be a good option. Otherwise, if you want to go with a debt-fund route, liquid funds also compare well with FDs, so you could also put your money into liquid funds. So, as we discussed earlier, arbitrage funds work well for money you have for a 2-3 year period. FDs can also work well. You can decide where to keep which kind of money. But to build long-term wealth, you should definitely have some exposure to equity mutual funds or the stock market.
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