Arbitrage Fund Explained: What SEBI’s Category Rules Actually Require

An arbitrage fund is a mutual fund that tries to earn the gap between a stock’s price in the cash market and its price in the futures market. It buys the share, sells the matching future, and waits for the two prices to meet at expiry. No view on whether the market goes up or down. Just the spread.

That sounds almost too tidy, so we want to slow down and look at what the rules actually say, how one trade works with real arithmetic, and where the returns can disappoint. Everything about the category below comes from SEBI’s Master Circular for Mutual Funds dated March 20, 2026, the consolidated rulebook updated in line with the SEBI (Mutual Funds) Regulations, 2026, which came into force on April 1, 2026.

What SEBI says an arbitrage fund must be

SEBI sorts every open-ended scheme into fixed categories, and arbitrage funds sit in the hybrid bucket, listed sixth after conservative, balanced, aggressive, dynamic asset allocation and multi asset allocation funds. The circular describes the category in a few lines, and each line matters:

• Strategy: the scheme follows an arbitrage strategy. Its uniform description has to read “An open ended scheme investing in arbitrage opportunities.”
• Equity floor: at least 65% of total assets must be in equity and equity related instruments.
• Defensive allocation: what the fund does under defensive considerations has to be stated in the Scheme Information Document (SID).
• Debt side: the debt exposure is meant for liquidity and margin needs, and is limited to CDs, government securities with maturities up to one year, and units of liquid, money market or other schemes with a Macaulay duration of less than one year.
• No InvITs: the circular says no investment in InvITs is permitted, and it repeats the point when it lets other hybrid schemes put their residual portion in InvITs “except for arbitrage funds”.

One more rule shapes what you see on fund platforms. Paragraph 3.10.1 of the circular allows only one scheme per category for each fund house, with exceptions for index funds and ETFs tracking different indices, fund of funds with different underlying schemes, and sectoral or thematic funds. So an AMC can run one arbitrage fund, not three slightly different ones.

The 65% equity floor tells you what the fund holds. It does not tell you how much market risk it carries, because almost all of that equity is hedged with futures.

That last point trips people up. On paper an arbitrage fund looks like an equity-heavy scheme. In practice, the long shares are paired with short futures, so a fall in the stock is largely offset by a gain on the future. The fund is equity by holding, closer to a short-term debt product by behaviour.

How an arbitrage fund earns: one hypothetical trade

Let’s build a single trade with made-up numbers. Say a stock, XYZ Ltd, trades at ₹1,000 in the cash market. Its near-month future, with about a month to expiry, trades at ₹1,005.50. Futures usually trade above the cash price because of the cost of carry, the interest you would otherwise earn on the money tied up in the shares. We covered the mechanics in our piece on cost of carry in futures.

The fund does two things at once:

1. Buys XYZ shares in the cash market at ₹1,000.
2. Sells the same quantity of XYZ futures at ₹1,005.50.

The locked-in spread is ₹5.50 per share, or 0.55% of the ₹1,000 deployed. On expiry day the futures contract settles against the cash price, so the two prices converge. Now watch what happens under two very different outcomes.

Same ₹5.50 either way. That is the whole idea. The direction of the market drops out, and what remains is the spread you captured on day one, before costs. If a fund could do this every month at 0.55%, the simple annualised figure would be about 6.6% (0.55% × 12), again before brokerage, taxes on transactions, expenses and the drag of the cash it keeps aside for margins.

We picked 0.55% only to keep the arithmetic clean. Real spreads change every day and differ from stock to stock, and they are the single biggest driver of how an arbitrage fund does. The same buy-cash, sell-futures logic is explained from a trader’s angle in our guide to cash and carry arbitrage.

What decides the spread

The fund manager doesn’t set the spread. The market does. A few forces push it wider or narrower:

• Interest rates. Since the spread is mostly a carry cost, it tends to move with short-term rates. When money is costlier, futures usually trade at a bigger premium.
• Demand for leverage. When traders are keen to go long through futures, futures get bid up and the premium widens. In quiet, cautious markets the premium can shrink.
• Money chasing the same trade. Arbitrage is a crowded game. When large amounts of capital hunt the same spreads, the easy gaps close faster.
• Corporate actions. Dividends, splits and other events change the fair price of a future and can make a particular stock’s spread look odd for a while.

This is why returns on these funds are uneven. Some months the spreads are fat; some months they are thin, and the fund’s debt portion does more of the work.

Rollover: the trade doesn’t really end

A one-month trade ends at expiry, but the fund wants to stay invested. So near expiry it either lets the position settle and opens a fresh one in the next month, or rolls it: buys back the expiring future and sells the next month’s contract. The new spread on the next-month contract becomes the next month’s return. If you want the trader’s version of this, our explainer on Nifty futures rollover walks through it.

Rolling has a cost. Every roll means fresh brokerage and transaction charges, and the next spread might be lower than the one just closed. A fund doing this across dozens of stocks, every month, is running a fairly busy operation for what looks like a sleepy product.

Arbitrage fund vs equity savings fund vs balanced hybrid fund

The circular’s hybrid table makes the differences clear, and they are easy to mix up because all three can carry a lot of equity.

Read that middle row carefully. An equity savings fund also uses arbitrage, but it keeps a slice of unhedged equity, the “net long” part, so it moves with the market more than an arbitrage fund does. A balanced hybrid fund is the opposite: its equity is meant to be real equity exposure, with arbitrage ruled out.

If you want market returns, an arbitrage fund is the wrong tool. If you want to park money without betting on the market, it is built for exactly that.

Where the risk actually sits

“Hedged” is not the same as “riskless”. Here is what we would watch:

• Thin spreads. The fund cannot earn more than the market offers. When spreads compress, returns compress with them.
• Daily NAV wobble. Before expiry, the cash and futures legs are valued at their own market prices, and the gap between them moves around. The NAV can dip on a given day even though the trade is on track to converge at expiry.
• Execution and tracking. Buying and selling both legs at the intended prices across many stocks is not trivial. Small slippages add up.
• The debt portion. SEBI keeps it short-term, but it is still credit and interest-rate exposure, and its quality depends on the fund’s choices within those limits.
• Costs and exit loads. Expense ratios and exit loads vary by scheme. Check the SID and Key Information Memorandum of the specific fund before you invest.

For a wider framework on thinking about downside before you commit money, our pillar guide on risk management in trading is useful even if you never trade futures yourself.

Who an arbitrage fund suits

People usually look at these funds for money they want to keep away from market swings for a few months, but still want to earn something on. A business owner parking surplus cash, an investor sitting on sale proceeds while deciding what next, or someone stepping money out of equity in stages are typical cases.

It suits people less well if they need the money within days, since redemption takes time and exit loads may apply, or if they expect returns well above short-term rates. The fund’s return is tied to spreads, and spreads are tied to rates. There is no clever trick that turns it into an equity fund in a good year.

Tax is a separate question decided by income-tax law, not by SEBI’s category rules, and rates and holding-period rules have changed in recent budgets. Check the current position on the Income Tax Department’s portal or with a tax adviser before comparing an arbitrage fund’s post-tax return with a bank deposit or a liquid fund.

A quick checklist before picking one

1. Read the SID’s asset allocation table, including the defensive allocation SEBI requires it to state.
2. Look at the fund’s size relative to the market. A very large fund has to find a lot of spreads every month.
3. Compare expense ratios across direct plans. On a product with modest gross returns, costs eat a bigger share.
4. Check the exit load and how long it applies.
5. Look at the benchmark. The circular names the NIFTY 50 Arbitrage and CRISIL Arbitrage Index as arbitrage indices AMCs can use when building benchmarks for income plus arbitrage fund of funds. Check which index your fund uses and how it has done against it.

The short version: an arbitrage fund is a rules-bound hedging machine. SEBI fixes the shape, the futures market fixes the return, and the fund manager’s job is to capture the spread cheaply and keep the debt side clean. Knowing that, you can judge one on the things that actually matter.

Disclaimer: This article is for educational purposes only and is not investment, tax or legal advice. XYZ Ltd and all prices, spreads and returns in the example are hypothetical. Category rules are summarised from SEBI’s Master Circular for Mutual Funds dated March 20, 2026 and may be amended; read the scheme documents and consult a SEBI-registered adviser before investing.