Why 65% Equity Can Mean Lower Risk and Better Tax Efficiency: Arbitrage Fund Are Taxed Like Equity Funds Explained

A fund can own more than 65% in shares and still behave very differently from a conventional equity fund. An arbitrage fund typically pairs shares purchased in the cash market with an offsetting futures position. The shares remain in its portfolio, but much of their exposure to market direction is hedged.

That creates the puzzle: a fund whose returns may resemble a short-term income product can qualify for equity mutual fund taxation. The explanation lies in the difference between what a fund owns, how it offsets risk, and which holdings the tax law counts. Understanding those differences matters more than the attractive-sounding tax label.

How Does an Arbitrage Fund Actually Earn a Return?

Suppose a share costs ₹1,000 today while its near-month futures contract trades at ₹1,008. A fund purchases the share and simultaneously enters a contract to sell it at the futures price. If cash and futures prices converge by expiry, the ₹8 difference is the starting point for the trade's return. If the share falls, the cash position loses value while the short futures position generally gains; if it rises, the reverse occurs.

The ₹8 is not a promised profit to the investor. Brokerage, securities transaction taxes where applicable, other trading costs, the expense ratio, the timing of closing or rolling the trade and imperfect hedges affect the result. The fund also holds cash or debt instruments, whose returns and risks contribute to its NAV. Its investment objective is to capture spreads while controlling exposure to broad share-price movements, not to predict which shares will rise.

How Can 70% Equity Exposure Produce Much Lower Equity Market Risk?

Imagine a simplified portfolio worth ₹100. It owns ₹70 of domestic listed shares, holds ₹30 in debt and cash, and has sold futures equivalent to ₹65 of the shares. These are not three slices that add up to ₹165: the futures contract offsets existing holdings rather than representing another ₹65 spent on assets.

A person reading only the 70% shareholding could expect a sharp stock-market fall to cause a similar fall in the fund. But if the hedge is effective, losses on shares are largely offset by gains on the corresponding futures. The fund can still experience temporary NAV declines from changing spreads, basis risk, the unhedged slice, trading costs and the debt portfolio. Gross equity exposure is not the same thing as net equity market risk.

Why Do Arbitrage Funds Qualify for Equity Mutual Fund Taxation?

SEBI places arbitrage schemes in the hybrid arbitrage fund category. Their strategy and scheme documents generally provide for at least 65% in equity and equity-related instruments under normal circumstances. That scheme category, however, is a separate concept from the tax-law test. For the ordinary equity-oriented fund route relevant here, the tax definition requires at least 65% of total proceeds in equity shares of domestic companies listed on a recognised stock exchange. It measures that shareholding using the annual average of monthly averages of opening and closing figures, rather than one snapshot on redemption day. Equity-related instruments in a scheme's investment mandate must not automatically be treated as qualifying domestic shares for this tax test.

The short futures position can substantially hedge the economic risk of the shares without making those owned shares vanish from the portfolio. This is the source of the apparent contradiction. Qualification must still be checked for the actual scheme and the applicable period; an investor should not assume that its name or one factsheet percentage proves its tax status. Arbitrage funds are not debt mutual funds, even when their return pattern resembles one. Their hybrid scheme classification, equity-oriented tax status and hedged risk profile answer different questions.

How Are Arbitrage Fund Gains Taxed in 2026?

For a qualifying equity-oriented fund, redemption after 12 months or less produces short-term capital gains, generally taxed at 20% when the securities transaction tax conditions are met. Redemption after 12 months produces long-term capital gains, generally taxed at 12.5% only on the investor's aggregate eligible equity long-term gains above ₹1.25 lakh in the financial year. The ₹1.25 lakh limit is shared across qualifying equity shares, equity-oriented funds and business trust units; it does not reset for each investment. Applicable cess and surcharge can increase the final bill.

Tax arises on the gain when units are redeemed, rather than as an annual fixed percentage of the amount invested in the growth option. For example, ₹10 lakh growing to ₹10.70 lakh after more than 12 months creates a ₹70,000 gain. If the investor has no other eligible equity long-term gains that financial year and can use the entire ₹1.25 lakh threshold, the tax on that gain is zero. If the allowance is already used elsewhere, the illustrative tax is ₹8,750 before cess, or ₹9,100 including 4% cess, leaving ₹10,60,900. The fund's return and the investor's wider tax position both matter.

Arbitrage Fund vs Debt Fund, Liquid Fund and FD: What Does Tax Change?

A useful comparison holds returns constant. Assume ₹10 lakh is invested at the same hypothetical 7% annualised gross return in every product, with returns compounded until the stated horizon. Here “gross” means before the investor's personal tax, but after any product-level expense or yield adjustment: actual products will rarely deliver identical returns. Assume a resident individual, no surcharge, 4% health and education cess, no other equity long-term gains, the full ₹1.25 lakh threshold available in the redemption financial year, and units of the debt and liquid funds acquired after 1 April 2023. Ignore exit loads and the timing differences in paying deposit tax for this controlled illustration.

A typical debt fund or liquid fund investing more than 65% in debt and money-market instruments, measured as the annual average of daily closing figures, falls within the 2026 “specified mutual fund” definition. Gains on the relevant newly acquired units are deemed short term regardless of the holding period and taxed at the investor's applicable slab rate. FD interest is also generally taxed at the applicable slab rate, although interest tax can arise as it accrues, even if the deposit has not matured. For this narrow tax experiment they share the same modeled tax amount; their investment risks and actual cash flows do not.

Rounded to the nearest rupee. Effective annualised post-tax returns for the arbitrage illustration are approximately 5.52%, 7.00%, 6.88% and 6.62% across the four periods. For the 30% slab comparator they are approximately 4.79%, 4.82%, 4.87% and 4.92%, respectively. The FD columns simplify the timing of tax on accrued interest and do not include tax deducted at source, which is an advance credit rather than an additional tax. The 20% and 30% labels assume those are the relevant marginal rates under the person's applicable tax regime; cess brings them to 20.8% and 31.2%.

The six-month row is revealing: for the 20% slab investor there is no tax-rate advantage in this example, because the arbitrage gain also faces a 20% base short-term rate. At 13 months, the assumed unused equity long-term gain threshold changes the result. By year three, some of the gain exceeds that threshold, so the arbitrage investor also pays tax. A different acquisition date or a debt scheme that fails the specified-fund test can produce a different tax result; “all debt funds are slab-taxed forever” is not an accurate rule.

The changes have a history. The April 2023 reform removed the usual long-term treatment for specified fund units acquired from that date. Rates on qualifying equity short-term and long-term gains changed from 23 July 2024. The definition of a specified mutual fund was subsequently narrowed from the older domestic-equity test to the current debt and money-market allocation test. That is why old articles and broad “debt fund tax” claims can mislead a 2026 comparison.

When Is the Tax Advantage Large Enough to Matter?

Tax on a return is only one side of the comparison. Suppose a 13-month investment would generate a 7% annualised return in a qualifying specified debt fund and the investor's marginal rate is 30% plus cess. With slab tax, each ₹100 of gain retains ₹68.80, so the annualised debt return nets approximately 4.82% under the illustration's simplified end-of-period tax treatment. An arbitrage fund whose long-term gain remains entirely within the investor's unused ₹1.25 lakh allowance could produce about 4.82% before personal tax and match that outcome. At a 20% slab plus cess, the corresponding break-even is approximately 5.54%.

These are conditional break-evens, not target returns. If the allowance has been used, the arbitrage gains face 12.5% plus applicable cess and the hurdle changes. If the arbitrage fund earns a lower return because spreads have narrowed, or an exit load applies, a tax saving can disappear. Its expense ratio is already reflected in published NAV returns; deducting it again from a published return would double count it. Compare realistic net-of-fund-expense returns and the same holding period before calculating personal tax.

The size and timing of gains matter too. One investor might redeem several equity funds in the same year and exhaust the ₹1.25 lakh threshold; another might have plenty left. An investor using a different tax regime, facing surcharge, offsetting eligible losses or owning older debt-fund units may arrive at a different post-tax result. A label on the fund cannot substitute for the investor's own calculation.

Why Do Arbitrage Fund Returns Change With Market Conditions?

The cash-futures spread is the central moving part. When demand for futures, funding costs, volatility or traders' positioning change, the price of a futures contract relative to its underlying share can change too. Wider available and executable spreads can improve the return on new trades, while narrower spreads may lower it. Existing positions can show mark-to-market fluctuations before convergence, and managers may roll expiring positions at less attractive new spreads.

A falling market does not mechanically produce better arbitrage returns. The relevant question is what spreads are available after costs and how much capital the fund can deploy at those spreads. As more money competes for similar trades, opportunities can compress. The debt and money-market holdings can also change the fund's total return as interest rates, credit conditions and portfolio choices evolve. A trailing one-year return describes the past combination of these factors; it is not a fixed yield offered for the next year.

What Happens to an Arbitrage Fund When the Stock Market Falls?

If a matching share and short futures position both move with the market, a share-price drop hurts the owned share but helps the futures leg. That is why a large Nifty 50 decline need not translate into a comparable arbitrage fund decline. The ₹5 residual equity position in our example, imperfect matches and changes in the cash-futures spread still leave room for movement in NAV.

This also explains why an arbitrage fund should not be benchmarked against a conventional equity fund merely because both can receive equity-oriented taxation. A large-cap equity fund usually seeks long-term participation in share-price growth; an arbitrage fund mainly seeks to capture price differences between related positions. Tax classification, underlying holdings, economic exposure and return objective should be read separately.

Arbitrage Fund vs Liquid Fund: Which Differences Matter in Practice?

Both may appear on a shortlist for money needed in the relatively near future, but their return engines differ. A liquid fund invests in very short-maturity debt and money-market instruments. Its NAV is shaped by the income and valuations of those holdings, along with credit, liquidity and interest-rate risks. An arbitrage fund relies substantially on hedged equity-market price differences plus the performance of its debt and cash sleeve.

Liquidity and costs need checking at the scheme level. The two categories can have different redemption timelines and exit-load schedules, and an exit load can overwhelm a small expected gain on a very short holding period. Neither offers a deposit-style guaranteed rate. An FD differs again: the contracted interest and applicable premature-withdrawal terms can make its cash flow more predictable, while the institution, tenor, deposit insurance limits and taxation require their own assessment. These are reasons to compare the products by purpose and time horizon, not by tax alone.

What Can Go Wrong, and What Should Investors Check?

Arbitrage opportunities can shrink, expenses can consume a meaningful part of a modest spread, and short-horizon exit loads can reduce proceeds. NAV may fluctuate when hedge prices temporarily move apart or the unhedged and debt holdings change value. Futures positions require collateral, settlement and careful execution; the debt sleeve brings liquidity, credit and interest-rate risks of its own. Scheme documents explicitly do not guarantee that the investment objective will be achieved, and the riskometer should be checked in the latest factsheet rather than inferred from the word “arbitrage”. Tax laws and the scheme's own portfolio can change as well.

Before comparing schemes, inspect the latest factsheet for domestic cash-equity holdings, offsetting derivative positions and any net directional exposure; read the debt portfolio's credit quality and maturity profile. Check the direct or regular plan expense ratio, exit load, redemption rules, scheme size and consistency of returns across periods with different market conditions. Finally, match those observations to the date the money is needed, the availability of the equity long-term gain threshold and the after-tax return of plausible alternatives. A ranking based on last year's return misses most of the decision.

The central lesson is that tax law examines qualifying portfolio holdings while investment risk depends on how those holdings interact. Substantial gross domestic shareholding can coexist with a much smaller directional equity exposure and, when the statutory conditions are satisfied, equity-oriented fund taxation. The useful figure for an investor is the plausible return after fund costs, any exit load and personal tax, set against the risk taken over the actual holding period. Monitor the spread environment, hedge quality and debt sleeve alongside the tax treatment.