In addition to generating returns comparable with debt options, arbitrage funds also enjoy the tax advantage of equity funds.

Arbitrage fund investors had been worried about the category being clubbed under non equity funds in the recent Budget. As this did not happen, there is relief among them as they can continue to enjoy tax benefits.

Arbitrage funds cash in on the opportunities that exist between the spot and the futures market. They pair trade--buy in the spot or cash market, while simultaneously locking-in a higher price for the same in the futures market. They pocket the difference when the sale actually happens. Their risk profile is very low--comparable to short term debt funds. Fund managers try to maintain their equity holdings in the cash market above the 65% mark, so that these schemes are classified as equity funds. Equity funds do not incur capital gains tax if held for more than one year and, if held for less than a year, short-term capital gains are taxed at 15%. Debt mutual funds, if held for less than three years are considered short-term assets and taxed at marginal rates. The dividends from arbitrage funds are also tax free because there is no dividend distribution tax on equity funds. It is not just the tax advantage that has made arbitrage funds attractive for investors. These funds have also been generating better returns compared to short-term debt funds which do not take risky duration calls--pure interest accrual products like liquid funds or ultra short-term debt funds. Their returns are also significantly higher than the long-term bond yield (yield to maturity) of around 7.1-7.3% offered by tax-free bonds listed in the market.

The higher levels of the stock market have also led to higher volatility--the BSE 1-Month Realised Volatility Index has moved up to around 16 from around 4 on 1 January. This increased volatility is also generating enough arbitrage opportunities, and they are likely to last as well. There are good arbitrage opportunities now and the situation should remain like this so long as the stock market remains firm.

Investors need to move a part of their debt portfolio to arbitrage funds to enjoy the twin benefits of tax advantage and better returns. With the government flip-flopping on taxation issues, the tax advantage may cease in the future, so those looking for investment opportunities for less than three years stand to benefit the most. However, if you invest before 30 March, you can still reap the tax benefits, even if the government shifts this category to non-equity funds in the next Budget, as it will be effective only from April 2016. You still have one full year to redeem your investment with tax free capital gains.

However, these schemes may not be suitable for very short-term investors--those who want to park their money just for a few days. Though these schemes make paired trades and lock-in the possible gains, these gains are realised only at the end of the futures and options cycle. Since both the cash and the futures market transactions are separately valued on a mark-to-market basis--at current market values--there might be short-term volatility in their net asset values. Exit load is another problem that is faced by short-term investors. Most schemes charge exit load if units are redeemed in less than 90 days. The exit load varies between 0.25 and 0.50%. If you want to invest in arbitrage funds, but are unlikely to stay invested for more than three months, go with the schemes that charge lesser exit load.

The qualifying criterion to invest in an arbitrage fund should be their equity funds tag--they are popularly known as equity arbitrage funds (we included only these funds in our study). Asset under management (AUM) is another good criteria to select a fund-schemes with high AUM are likely to have a dedicated arbitrage desk and, therefore, are likely to be better at spotting arbitrage opportunities and generating higher gross yield. We did not consider schemes with less than `100 crore AUM for our study.