Let us look at the pre-tax returns first. In the year 2024, the arbitrage funds, on an average, gave tad over 9% returns. That is very attractive and you are getting a debt product yielding 9%. The arbitrage funds buy in spot equity and sell in the futures market, but are effectively proxy for a short-term debt fund. Difference is that as the volatility in the equity markets goes up, the arbitrage transactions get a much higher spread. These are locked in spreads, so there is no risk of not getting such returns. The returns were as high as 8% in 2023 too, so it is a 2-year rally. 

The second aspect that makes arbitrage funds attractive is the tax aspect. This is more relevant to HNIs, who happen to be one of the big markets for arb funds. The arbitrage funds are classified as equity funds for tax purposes due to the equity component being more than 65%. What you are getting is a debt fund with tax treatment like equities. On the LTCG, you just have to pay 12.5% tax; and that too after the base exemption of ₹1.25 lakhs is exhausted. That makes the arbitrage funds incredibly attractive in terms of tax efficiency. It is not just the HNI crowd, but now even the retail investors are acquiring a penchant for arbitrage funds. 

That is a tough call. Even in the past, we have seen that arb funds have given very high returns for short periods of time, but they have also been through long periods of lull in terms of returns. On an average, the arbitrage spreads have also been compressed to as low as 4% to 5% in a year after considering the execution and other costs. If volatility tapers in the market, we could see arbitrage fund returns also waning. The second story is about the interest rates. Since arbitrage spreads reflect short term interest rates, any cut in interest rates will also be in tandem with a fall in arbitrage spreads. These are the 2 factors that can change the narrative against the arbitrage funds and make it less attractive for parking. 

Remember, while arbitrage funds are classified as equity funds for income tax purposes, they are actually like liquid funds and must be treated as such. At best, arbitrage funds are meant to park funds for the short term and maintain portfolio liquidity. They do not have a much bigger role. However, there is one more area that retail can explore. In the case of systematic transfer plans, it is important to be able to get funds out of the debt fund in a tax efficient manner. Here again, you can use arbitrage fund as the base and then sweep funds out of the arbitrage fund into an equity fund. That would be tax efficient also!