Volatility makes most investors uncomfortable. It forces decisions under pressure, distorts risk perception, and creates the kind of uncertainty that pushes people toward either excessive caution or reckless positioning. But within that same volatile environment, a specific category of fund quietly does its best work — and most retail investors have barely heard of it. 

The arbitrage fund deserves considerably more attention than it currently gets. 

How Arbitrage Funds Actually Generate Returns 

The mechanism behind an arbitrage fund is not complicated, but it is widely misunderstood. These funds simultaneously buy a stock in the cash market and sell it in the futures market when a price difference exists between the two. That difference — the spread — is locked in as profit regardless of which direction the underlying stock moves. The position is hedged from the moment it is entered. 

This means an arbitrage fund does not take a directional view on markets. It does not need the Nifty to go up or down. It needs price inefficiencies between cash and futures segments — and those inefficiencies expand precisely when markets are volatile, uncertain, and being driven by emotional rather than rational pricing. 

Volatile markets are, counterintuitively, the best environment for arbitrage fund returns. Wider spreads are generally the result of greater volatility, giving the fund more chances to lock in large gains. 

Why Volatile Periods Are Where These Funds Shine 

Most market participants instinctively reduce exposure during uncertainty. Equity positions get trimmed. Index mutual funds face redemption pressure as investors move to safety. That collective retreat from risk assets creates exactly the pricing dislocations that arbitrage funds are structured to exploit. 

When index mutual funds are experiencing outflows and equity prices are swinging sharply between cash and derivative segments, arbitrage fund managers have a wider menu of opportunities to work with. The spread between spot and futures prices widens. Rollover costs increase. And the fund captures those differentials systematically, session after session, without the downside exposure that pure equity allocations carry through the same period. 

For investors who want to stay deployed during volatile phases without accepting full market risk, this characteristic is genuinely valuable. 

The Tax Treatment That Changes the Calculation 

An arbitrage fund holds at least 65 percent of its portfolio in equity and equity-related instruments, which qualifies it for equity taxation under Indian tax laws. Gains held for more than twelve months attract long-term capital gains tax rather than the higher rate applicable to debt instruments. 

This tax treatment puts arbitrage funds in a significantly more favourable position than liquid funds or short-duration debt options — even when the pre-tax returns are comparable. For investors in higher tax brackets, that differential matters more than most people calculate upfront. 

What Anand Rathi Share and Stock Broker Advises 

Advisors at Anand Rathi Share and Stock Broker recommend arbitrage funds primarily as a parking vehicle for medium-term surplus — capital that cannot go into index mutual funds due to a shorter horizon or lower risk tolerance but should not sit idle in savings accounts either. 

Anand Rathi Share and Stock Broker advisors also highlight the combination of arbitrage and index mutual funds within the same portfolio as a practical way to balance growth exposure with low-volatility returns across different time horizons. 

Knowing which instrument handles which job is what portfolio construction is actually about. 

Author Bio : Mehak is a Digital Marketing Strategist and SEO Specialist with over 12 years of experience in helping businesses grow their online presence. Since beginning his career in 2013, he has successfully worked across industries including healthcare, education, technology, and e-commerce. He specializes in search engine optimization (SEO), content marketing, keyword strategy, and link building, with a strong focus on delivering measurable results. Lokesh has helped brands achieve top rankings on Google through data-driven strategies, high-quality content, and ethical SEO practices aligned with search engine guidelines.