Income Plus Arbitrage Fund of Funds: How SEBI Lets a FoF Mix Debt and Arbitrage Schemes

An income plus arbitrage fund of funds is a mutual fund that does not buy bonds or shares itself. It buys units of other mutual funds: some debt-oriented schemes, and the rest arbitrage schemes. SEBI caps the debt-fund side at 65% and says everything else must sit in arbitrage funds. That one line of regulation is the whole product, and it explains why so many AMCs have been pitching it to people who used to park money in plain debt funds.

Why the sudden interest? Mostly tax. Since debt funds lost their long-term capital gains benefit, investors have been looking for something that behaves a bit like a debt fund but is not taxed like one. This category was built to sit right on that line. Let us look at what the rules actually say, how the structure works with numbers, and what you give up for the tax angle.

What SEBI’s rules say about an income plus arbitrage fund of funds

The source document is SEBI’s Master Circular for Mutual Funds dated March 20, 2026, issued alongside the SEBI (Mutual Funds) Regulations, 2026, which came into force on April 1, 2026. Paragraph 3.8.6 points to a framework for fund of funds (FoFs) with more than one underlying scheme, first sent to AMFI on June 30, 2025 and reproduced as Annexure 1C.

In that annexure, “Income plus Arbitrage FOF” is listed as a sub-category of Hybrid FoF (Domestic), next to aggressive hybrid, conservative hybrid, dynamic asset allocation and multi-asset FoFs. The description is short:

• Investment in underlying debt-oriented schemes: up to 65%.
• The balance goes only into arbitrage-based underlying schemes.

Two other rules from the same annexure matter. First, an FoF must keep at least 95% of total assets in the underlying funds, and the remaining slice cannot work against the scheme’s strategy. Second, an AMC can run the category in three flavours: an Active option (only active underlying funds), a Passive option (only passive ones) and an Active and Passive option. The naming table in Annexure 1C(iii) fixes the labels as “Income plus Arbitrage Active FOF”, “Income plus Arbitrage Passive FOF” and “Income plus Arbitrage Omni FOF” for the mixed version.

And each AMC gets one scheme per option in this sub-category, according to Annexure 1C(iv). So a fund house can have at most three of these: one active, one passive, one omni.

Why the 65% line exists

The number is not random. Under the tax rules quoted in AMC material, a fund of funds that puts 65% or more into debt-oriented fund units and debt and money market instruments is treated like a “specified” debt fund, and its gains are always short-term, taxed at your slab rate. Keep the debt side below 65% and the FoF falls into a different bucket.

Nippon India’s presentation for its Income Plus Arbitrage Omni Fund of Fund, citing the Income Tax Act, 2025 for units redeemed on or after April 1, 2026, sets it out this way (rates exclude cess and surcharge):

• A fund of funds investing 65% or more in debt fund units and debt and money market instruments: always short-term capital gains, taxed at your slab rate.
• A fund of funds investing less than 65% in those: slab rate if you hold for 24 months or less, and 12.5% if you hold for more than 24 months.

Look closely at the wording on both sides. SEBI allows debt funds “up to 65%”. The tax line is “less than 65%”. At exactly 65%, the fund would be on the wrong side for tax. That is why Nippon’s own document says its debt and money market exposure is to be kept below 65% at all points of time, with arbitrage at least 35%. In practice, fund managers run with a buffer.

SEBI says debt funds can go up to 65%. The tax rule rewards staying below 65%. The whole category lives in the gap between those two phrases.

A worked example: how the mix can drift

Here is a hypothetical portfolio, with made-up round numbers purely to show the arithmetic. It is not data from any real scheme.

Say an FoF starts with ₹100 crore: ₹60 crore in debt-oriented funds (60%) and ₹40 crore in arbitrage funds (40%). Over a few months, the debt funds do well and grow to ₹66 crore, while the arbitrage funds grow to ₹41 crore.

• New total: ₹66 crore + ₹41 crore = ₹107 crore.
• Debt share: 66 ÷ 107 = about 61.7%.

Still under 65%, but notice how it crept up by almost two percentage points without the manager buying anything. Now suppose investors put in fresh money and the manager is careless about where it goes. A few such moves and the fund is uncomfortably close to the line. This is why these schemes rebalance regularly and rarely sit right at 64.9%. For you as an investor, the takeaway is simple: read the factsheet’s actual allocation, not just the scheme name.

A worked example: what the tax difference looks like

Again, a hypothetical case. You invest ₹10 lakh and redeem after 26 months with a gain of ₹1,20,000. Assume you are in the 30% slab, and ignore cess and surcharge to keep it clean.

• Income plus arbitrage FoF (below 65% debt), held over 24 months: 12.5% of ₹1,20,000 = ₹15,000.
• A specified debt fund, same gain: always short-term, so 30% of ₹1,20,000 = ₹36,000.
• Difference: ₹21,000 in this example.

Now change one thing. Redeem the FoF after 20 months instead. You are inside the 24-month window, so the gain is taxed at your slab: ₹36,000, the same as the debt fund. The tax edge only shows up if you actually stay invested beyond two years. If your money is meant for something 12 or 18 months away, this structure gives you no tax benefit at all.

Compare that with a plain arbitrage fund. The same Nippon document lists it at 20% for gains held up to 12 months and 12.5% after 12 months. So a pure arbitrage fund reaches the 12.5% rate faster. The FoF’s pitch is that you get a debt-heavy return profile, which a pure arbitrage fund does not give you. We explain how arbitrage funds earn their return in our guide to arbitrage funds and SEBI’s category rules.

The layered cost you pay

A fund of funds charges its own expense ratio, and the underlying schemes charge theirs too. SEBI’s master circular (paragraph 4.1.1) requires the scheme information document and advertisements of an FoF to disclose that investors bear the FoF’s recurring expenses in addition to the expenses of the underlying schemes. The same section bars the AMC from any revenue-sharing arrangement with the underlying funds; any commission or brokerage received from them must be credited to the FoF scheme’s account.

Here is how the layering adds up, with hypothetical expense ratios chosen only for illustration:

• FoF’s own expense ratio: 0.10%.
• Underlying debt funds, 60% weight, at 0.40%: contributes 0.24%.
• Underlying arbitrage funds, 40% weight, at 0.35%: contributes 0.14%.
• All-in cost: 0.10% + 0.24% + 0.14% = 0.48% a year.

On ₹10 lakh, that is ₹4,800 a year in this example. Plug in the real numbers from the factsheet of whatever scheme you are looking at; direct plans and regular plans will differ, and so will active versus passive underlying funds. The point is to add both layers before comparing it with a single debt fund.

The tax saving shows up only after two years. The extra layer of costs shows up every single day.

How the benchmark is supposed to be built

Annexure 1C(ii) of the master circular has a specific policy for this category’s benchmark, which is useful when you are judging whether a scheme is doing its job:

• The benchmark must represent both debt and arbitrage, in line with the weights in the scheme’s asset allocation.
• Each weight should be at least the minimum of that asset class’s allocation range.
• AMCs must pick from a short list. For debt: NIFTY Short Duration Debt Index, NIFTY Composite Debt Index, CRISIL Short Term Bond Fund Index or CRISIL Composite Bond Fund Index. For arbitrage: NIFTY 50 Arbitrage or CRISIL Arbitrage Index.
• Once chosen, the indices and their weights cannot be changed on an ad-hoc basis. Changing them needs due process, including prior intimation to or approval of SEBI.

SEBI even gives a cautionary example: it should not happen that the scheme’s actual debt investment is generally around 10% while the benchmark weight for the debt index is 50%. In other words, the benchmark must look like the portfolio. When you compare a scheme’s returns with its benchmark, check that the weights in the benchmark match what the factsheet shows.

Where it fits among similar products

It helps to place this FoF next to its cousins. A conservative hybrid fund holds a small slice of equity directly alongside its bonds, and we cover its limits in our explainer on the conservative hybrid fund. An equity savings fund combines equity, arbitrage positions and debt inside a single scheme; see our piece on the equity savings fund. The income plus arbitrage FoF does neither: it holds no direct stocks or bonds, only other funds, and its equity exposure comes through arbitrage funds that are hedged by design.

Nippon’s presentation also makes a practical claim about switching. If you hold a debt fund and an arbitrage fund separately and move money between them, each switch is a redemption, so it can trigger tax for you. Inside an FoF, the manager rebalances the underlying schemes and you are not taxed on that rebalancing; you pay tax only when you redeem your FoF units.

Risks people skip over

The label “income plus arbitrage” sounds safe, and the structure is designed to be low-volatility, but it is not risk-free.

• Interest-rate risk: the debt-fund side moves with bond yields. If the underlying debt funds hold longer-duration paper, a rise in yields can pull the NAV down for a while.
• Credit risk: it depends on what the underlying debt funds own. Check whether they are short-duration, corporate bond or credit-risk funds.
• Arbitrage spread risk: arbitrage returns depend on the gap between cash and futures prices, which shrinks in quiet markets.
• Tax rule risk: the whole case leans on a specific tax treatment. Tax law changes, and AMC documents themselves carry warnings to that effect.
• Allocation risk: if a scheme drifts to 65% or more in debt, the tax position for investors could change. Watch the monthly portfolio.

For a broader framework on sizing and limiting downside, our guide to risk management in trading is a good companion read.

A quick checklist before you invest

1. Confirm the scheme name follows SEBI’s format: Income plus Arbitrage Active, Passive or Omni FOF.
2. Open the latest factsheet and note the actual debt-fund share. It should be comfortably below 65%.
3. Add the FoF’s expense ratio to the weighted expense ratio of the underlying funds.
4. Match your holding period to the tax rule. Under 24 months, there is no tax edge.
5. Look at which debt funds it holds and what duration and credit quality they carry.
6. Compare returns with the scheme’s own benchmark, and check that the benchmark weights look like the portfolio.

The income plus arbitrage fund of funds is a fairly narrow tool. It suits money you can leave alone for more than two years and that you would otherwise put in debt funds. For shorter horizons, or if you are in a low tax slab, the advantage shrinks and the extra cost layer starts to matter more.

Disclaimer: This article is for educational purposes only and is not investment, tax or legal advice. All examples are hypothetical. Tax rules and SEBI regulations change; read the scheme documents and consult a SEBI-registered investment adviser and a tax professional before investing.