Best Arbitrage Funds: Your Alternative to Investing Money in Bank FDs?

The last few years have seen the peak of FD interest rates, largely driven by a series of repo rate hikes by the Reserve Bank of India (RBI) between May 2022 and February 2023. Thereafter, until December 2024, the RBI held the policy repo rate steady at 6.50%.

However, in its February 2025 bi-monthly monetary policy meeting, the RBI lowered the repo rate by 25 basis points (bps) to 6.25%.

The decision was in alignment with the central bank's objective of achieving the medium-term target for Consumer Price Index (CPI) inflation of 4.00% within a band of +/-2.00%, while supporting growth.

In January 2025, the CPI inflation eased to 4.31%, marking the lowest year-on-year inflation since August 2024. If the inflation continues to moderate and remains below the RBI's target range of 4-6%, the RBI may consider another repo rate cut in the April 2025 bi-monthly monetary policy meeting.

Should this happen, banks are likely to reduce FD interest rates in response, leading to lower returns for investors who rely on these fixed-income investment avenues.

In such a scenario, Arbitrage Funds can be an effective alternative to FDs. Arbitrage Funds carry lower risk than equity-oriented funds and offer better tax efficiency than debt mutual funds.

Let's understand more about Arbitrage Funds...

What Are Arbitrage Funds?

According to the Securities and Exchange Board of India (SEBI), Arbitrage Funds are mutual fund schemes that are required to follow an arbitrage strategy and invest at least 65% of their total assets in equities and equity-related instruments.

SEBI classifies Arbitrage Funds as a hybrid fund. These equity-oriented hybrid mutual funds seek to take advantage of arbitrage opportunities in the market.

While a minimum of 65% of the corpus goes to equity, the remaining 35% goes toward cash and debt instruments.

Arbitrage funds take full-hedged equity positions to benefit from the price difference (spread) between the spot and future market.

Key Traits of Arbitrage Funds

1. Hedged Strategy for Lower Risk

Following a hedged approach, arbitrage funds purchase securities in one market (the cash market) and simultaneously sell them in another (the futures market).

[Read: Mutual Fund vs Hedge Fund: Which One Should You Choose for Investment?]

This dual approach reduces risk by ensuring that the investment is relatively insulated from market price swings. Compared to other equity-oriented schemes the risk is lower.

The returns depend on the availability of arbitrage opportunities rather than the direction of the market, unlike equity funds.

2. Decent Returns in Unstable Markets

In volatile markets, such as the one we are currently navigating, arbitrage opportunities increase enabling Arbitrage Funds to clock better returns.

The returns are typically very modest compared to equity funds, yet they are better than what you could earn on bank FD.

3. High Liquidity

Given the arbitrage strategy followed as well as the potentially better returns than bank FDs, Arbitrage Funds are also looked up to as an alternative to Liquid Funds.

This makes them a suitable choice for investors seeking short-term investment opportunities or a place to park emergency funds.

4. Tax Efficiency

Arbitrage funds are treated as equity funds for taxation purposes, leading to significant tax advantages. This is probably the biggest advantage of Arbitrage Funds and the primary reason why many investors who are looking to invest for the short term are drawn to Arbitrage Funds.

In the case of Liquid Funds and bank FD, the capital gains and interest, respectively, are taxed as your income-tax slab, i.e. at the marginal rate of taxation. If you are in the highest income-tax bracket this could be a disadvantage.

Whereas for Arbitrage Funds the capital gains units held for up to 12 months before redemption are treated as Short-Term Capital Gains (STCG) and taxed at 20%. If the holding period exceeds one year, they are subject to Long-Term Capital Gains (LTCG) tax at the rate of 12.5% rate when such capital gains exceed Rs 1.25 lakh annually.

This makes arbitrage funds much more tax-efficient compared to many debt-oriented schemes, particularly for investors in higher tax slabs.

Owing to these traits, arbitrage funds have steadily grown in popularity over the past decade, particularly among conservative investors.

According to HYPERLINK "https://www.amfiindia.com/" \hAssociation of Mutual Funds in India (AMFI) data, arbitrage funds recorded the highest inflows in the hybrid funds category in fiscal 2024, exceeding Rs 90,000 crore.

As of January 31, 2025, the arbitrage fund category comprises 31 schemes and approximately 5.81 lakh investor folios. The net Assets Under Management (AUM) stand at Rs 2 trillion.

In the hybrid fund category, Arbitrage Funds have continued to witness positive flows with investors keen to capitalise on the market volatility.

In the hybrid funds category, Arbitrage Funds have drawn in nearly half of the inflows in January 2025.

Given that the equity markets are likely to remain volatile due to a mix of global and domestic factors in play, Arbitrage Funds may continue to witness inflows even going forward.

Returns from Arbitrage Funds

Over the past year, which was marked by near-continuous market volatility, several Arbitrage Funds have generated over 7% returns, according to AMFI data.

The table below outlines the 1-year returns of some of the top-performing arbitrage funds:

In contrast, many public sector banks such as the Bank of Baroda, Canara Bank, and the Union Bank of India offer FD interest rates between 6.70 - 6.80% for the same 1-year period. These rates may decline further if the RBI implements additional policy rate cuts.

Thus, with debt-like returns and equity-like taxation, arbitrage funds present an effective alternative to bank FDs.

Who Should Consider Arbitrage Funds?

Unlike other mutual funds, Arbitrage Funds rely on leveraging price differences between the cash and futures markets, making their returns less dependent on overall market movements.

This makes them a suitable option for investors with a low-to-moderate risk appetite potentially seeking slightly better returns than a bank FD, especially during periods of market volatility or economic uncertainty.

Additionally, these funds are well-suited for short-term financial goals and serve as an efficient investment vehicle for temporarily parking surplus funds, offering liquidity.

Having said that, Arbitrage Funds cannot be considered entirely risk-free, just like any other investment.

The performance of these funds depends on the availability of arbitrage opportunities. While they tend to perform well during periods of heightened volatility and uncertainty, such opportunities are not always present, which may lead to heavy portfolio churn and volatility.

Looking ahead, if arbitrage opportunities become scarce (spreads are lower), or if fund managers are unable to identify and capitalise on them in a timely manner, arbitrage funds may be unable to generate substantial returns.

Thus, you could consider arbitrage funds if you are an investor seeking equity exposure at low risk, and have a minimum investment horizon of around a year or so to ride out market volatility and benefit from arbitrage opportunities therein.

To Conclude...

With the possibility of the interest rate moving further down as CPI inflation eases, the environment becoming less favourable for bank FDs. In such a case, some allocation to some of the best Arbitrage Funds can prove to be meaningful and valuable for a diversified portfolio, balancing risks with decent returns.

That being said, it is crucial to ensure that the investments you align well with your investment objectives, risk profile, financial goals, and the time horizon to achieve those goals.

Be thoughtful in your approach.

Happy investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.