Arbitrage (arb) funds exploit mispricing between futures contracts and underlying assets and deliver average annual returns of about 6.5%; combining a passive index/ETF with an arb fund can replicate active-fund outcomes. A Securities Transaction Tax increase effective 1 April 2026 is estimated to lower arb annualised returns by 0.25–0.30%.
What are arbitrage funds
- Definition: Funds that capture price differentials between cash and futures markets (cash–futures arbitrage) and related corporate-action arbitrage.
- Risk profile: Low market risk on matched positions; described as having no credit risk for standard cash–futures arbitrage.
- Liquidity use: Short-term cash instruments and money-market instruments when arbitrage opportunities are absent.
- Specialised strategies: Corporate-action profit pools exist but often face AUM limitations (~Rs 3,000–5,000 crore) to avoid return dilution.
Performance, Costs and Constraints
- Average observed return ~6.5% p.a.; susceptible to reduction from higher transaction costs (STT impact 0.25–0.30% p.a.).
- Active large-cap fund fees ≈1% vs index funds ≈0.25% and ETFs <0.10%.
- Empirical finding: over 85% of active-fund returns derive from benchmark (beta); fees apply to entire portfolio, not just alpha.
Passive + Arb Replication Strategy
- Combine an index fund/ETF for beta with an arbitrage fund for incremental alpha to approximate active-fund return profile.
- Key limits: availability of arbitrage opportunities, transaction costs, and AUM scalability.
IASPOINT Booster Facts
- SEBI regulates mutual funds under the SEBI (Mutual Funds) Regulations; AMCs must be SEBI-registered.
- On 5 June 2026 Zerodha filed draft offer documents with SEBI proposing a Zerodha Arbitrage Fund.