Equity arbitrage funds are drawing renewed attention from investors and policymakers alike, emerging as a rare corner of the mutual fund universe where investor incentives, market efficiency and government revenue align neatly. These funds, which profit from price differences between the cash and derivatives markets, are increasingly being viewed as a low-volatility parking option with relatively attractive post-tax outcomes—especially for investors in higher tax brackets.
Kotak Mutual Fund Managing Director Nilesh Shah recently highlighted this balance, describing equity arbitrage funds as an example of a tax framework that mirrors Chanakya’s principle of collecting revenue gently, without harming the source. In a post on X, Shah pointed out that arbitrage funds generate steady, low-volatility returns while contributing significantly to government coffers through multiple layers of taxation and transaction-related levies.
Using the Kotak Equity Arbitrage Fund (KEAF) as an illustration, Shah said the scheme delivered a post-expense return of about 7.50% in FY25. However, short-term capital gains tax, including cess and surcharge, stood at roughly 23.92%. Beyond capital gains tax, arbitrage activity also generates revenue through securities transaction tax (STT), stamp duty, SEBI charges and GST on brokerage and transaction costs. Shah noted that KEAF incurred around Rs 1,050 crore in such expenses during FY25 on an average assets under management (AUM) of Rs 52,440 crore—about 2% of assets and nearly 27% of the fund’s net return.
When capital gains tax and transaction-related levies are combined, Shah estimated that close to 51% of the investor’s net return flowed to the government in FY25. Including counterparty transaction costs, total government revenue rose to nearly 78% of net returns. Despite this substantial tax outgo, Shah argued that equity arbitrage funds remain attractive for investors because their post-tax outcomes still compare favourably with many fixed-income alternatives.
Investors’ choice
The growing appeal of the category is also evident in industry data. According to AMFI’s November 2025 numbers, arbitrage funds recorded net inflows of Rs 4,192 crore in a single month, making them one of the largest contributors within the hybrid category. The category’s total AUM has climbed to Rs 2.75 lakh crore, reflecting growth of nearly 39.6% year on year. Between May and November 2025, cumulative net inflows stood at around Rs 55,374 crore, indicating that investor interest is structural rather than driven by a one-off spike.
Manish Srivastava, Executive Director at Anand Rathi Wealth, said arbitrage funds are benefiting from this shift because they currently sit in a “sweet spot” for investors. “Investors want a place to park money with low day-to-day volatility, but they also want returns that can stay competitive after tax,” he said. The strong inflow numbers, he added, underline how arbitrage funds are increasingly being used as a core parking and allocation tool rather than a tactical bet.
Taxation bit
A key driver of this trend is taxation. Arbitrage funds typically maintain more than 65% equity exposure through a mix of cash equities and equity derivatives, which allows them to be classified as equity-oriented funds. As a result, gains held for more than one year are taxed as equity long-term capital gains, which is significantly more favourable than the slab-rate taxation that applies to most debt fund gains and fixed-income interest for investments made in recent years.
This structural advantage makes arbitrage funds particularly attractive for investors in the highest tax brackets. Srivastava said that is why such funds are often recommended as a practical replacement for the shorter-duration debt portion of portfolios for high-income investors. “They aim to deliver debt-like steadiness, but with equity-style tax treatment if held long enough,” he said. In contrast, traditional debt instruments can become tax-inefficient at the top slab, where interest income or taxable gains are subject to high effective tax rates once surcharge and cess are added.
Debt funds vs Arbitrage funds
To illustrate the difference, a 7.5% return from a debt fund or fixed-income product, taxed at an effective rate close to 40%, would result in a post-tax return of roughly 4.6%. The same 7.5% return earned through an arbitrage fund and held for more than one year could translate into a post-tax return closer to about 6.4%, depending on applicable thresholds and tax treatment.
Even after accounting for transaction costs and scheme expenses, arbitrage funds continue to attract investor interest because they strike a balance between stability and tax efficiency. That said, Srivastava cautioned that they are not a universal substitute for all forms of debt exposure. Arbitrage funds are best suited for parking surplus funds and for short- to medium-term allocations, and investors should align their exposure with liquidity needs, holding periods and overall portfolio strategy.
As inflows continue to build, equity arbitrage funds are increasingly carving out a pragmatic middle ground—offering low volatility, relatively efficient post-tax returns and a tax structure that, for once, appears to work well for both investors and the exchequer.
Disclaimer: Business Today provides market and personal news for informational purposes only and should not be construed as investment advice. All mutual fund investments are subject to market risks. Readers are encouraged to consult with a qualified financial advisor before making any investment decisions.