Zerodha Arbitrage Fund Explained, How It Works, Taxation and Risks

Zerodha Fund House has entered the arbitrage fund category with the launch of the Zerodha Arbitrage Fund. Its New Fund Offer opened on August 12, 2026, closed on August 14, 2026, and the scheme has since opened for regular investment.

At first glance, this may look like another mutual fund launch. However, the bigger story is the category Zerodha has chosen. Arbitrage funds are increasingly used by investors to park surplus money because they combine relatively low directional equity risk with the tax treatment of an equity mutual fund.

That does not mean they are guaranteed, risk free, or automatically better than liquid funds and fixed deposits. To judge Zerodha's new fund, investors first need to understand how arbitrage funds generate returns, why taxation matters, and what can go wrong.

What Is the Zerodha Arbitrage Fund?

The Zerodha Arbitrage Fund is an open ended hybrid scheme that invests mainly in arbitrage opportunities in the equity cash and derivatives markets. The remaining money can be invested in debt and money market instruments.

There is no lock in. The fund normally invests 65% to 100% in equity and equity related instruments, including derivatives, and up to 35% in debt, money market instruments, cash and cash equivalents.

The important phrase here is including derivatives. A high equity allocation does not mean the fund is taking the same market risk as a diversified equity fund. Most of the equity position is expected to be hedged by an opposite futures position.

What Exactly Is an Arbitrage Fund?

Arbitrage means trying to earn from a temporary price difference for the same asset in two parts of the market.

Suppose a stock is available for ₹1,000 in the cash market, while its futures contract is trading at ₹1,008. An arbitrage fund can buy the share for ₹1,000 and simultaneously sell its futures contract for ₹1,008.

As the futures contract gets closer to expiry, the cash and futures prices normally move towards each other. The fund tries to capture the ₹8 difference, after transaction costs and expenses.

This is only a simplified example. An actual arbitrage fund carries out many such trades across different securities and also manages cash, collateral and debt investments.

How Does an Arbitrage Fund Make Money?

An arbitrage fund has two main return sources.

The first is the cash futures spread. The fund buys a share and sells its futures contract at the same time. Since gains or losses on one side are largely offset by the other, the return depends mainly on the price gap rather than on whether the share market rises or falls.

The second source is the debt and money market portfolio. Money that is not used for arbitrage trades, as well as cash kept for margin and liquidity needs, may be invested in instruments such as treasury bills, certificates of deposit, government securities and tri party repos.

This is why an arbitrage fund can hold a large equity portfolio but behave more like a short term fixed income product. Its equity exposure is largely hedged, while a normal equity fund remains exposed to stock price movements.

Do Rising Markets Mean Higher Arbitrage Fund Returns?

No. A strong stock market does not automatically increase arbitrage fund returns.

The fund earns from the spread between cash and futures prices, not from simply owning rising stocks. Its return is influenced by short term interest rates, demand for futures positions, market liquidity, transaction costs and the number of attractive arbitrage opportunities available.

Volatility can sometimes widen spreads and create more opportunities. However, volatility alone does not guarantee better returns. If too much money is chasing the same trades, spreads can shrink even when markets are moving sharply.

Why Are Arbitrage Funds Taxed Like Equity Funds?

For tax purposes, an equity-oriented mutual fund generally needs to maintain the required exposure to equity shares of domestic companies. Arbitrage funds normally maintain at least 65% equity exposure, even though they hedge much of the related market risk through futures.

As a result, gains on arbitrage funds are taxed under the rules applicable to equity-oriented mutual funds. For units sold within 12 months, short-term capital gains are taxed at 20%. For units held for more than 12 months, long-term capital gains above the overall ₹1.25 lakh annual exemption threshold are taxed at 12.5%.

Applicable cess and surcharge may also apply. Tax rules can change, and an investor's final tax liability depends on individual circumstances.

Why Did Arbitrage Funds Become More Relevant After Debt Fund Tax Changes?

Taxation changed the relative appeal of different short term products. Under Section 50AA, gains from specified mutual funds acquired on or after April 1, 2023 are treated as short term capital gains, irrespective of the holding period.

From April 1, 2026, the definition focuses on funds that invest more than 65% of their proceeds in debt and money market instruments, along with certain fund of fund structures. Gains from such specified funds are generally taxed at the investor's applicable slab rate.

Arbitrage funds, in comparison, can qualify for equity taxation because of their equity allocation. This can improve their post tax outcome for some investors, particularly those in higher tax brackets. However, tax efficiency does not make an arbitrage fund safer, more liquid, or more suitable for every holding period.

How Big Is India's Arbitrage Fund Category?

The category has grown substantially. AMFI and CRISIL data show that arbitrage fund assets reached ₹2.91 lakh crore in July 2026, compared with ₹2.57 lakh crore in July 2025 and about ₹90,746 crore in July 2023.

That represents 13.5% growth over one year and 221.2% over three years. Arbitrage funds also received net inflows of ₹6,502 crore in July 2026, after inflows of ₹5,799 crore in June.

The growth supports the view that arbitrage funds are becoming a more important parking option. Still, category flows can be uneven. For example, the category recorded a net outflow of ₹21,114 crore in March 2026, showing that investors also withdraw heavily when liquidity needs or relative returns change.

What Returns Do Arbitrage Funds Actually Generate?

As of August 28, 2026, the arbitrage fund category had an average one year return of about 6.1%, according to INDmoney data. Individual one year returns ranged from around 5% to 7.5%, while several established schemes had three year annualised returns of roughly 7.3% to 7.6%.

These figures are useful for setting expectations, but they are historical returns, not promised yields. Arbitrage fund returns can rise or fall as cash futures spreads and short term interest rates change.

The relatively narrow range among many mature funds also explains why costs matter. When gross return opportunities are modest, even a small expense difference can affect what investors finally receive.

For example, if a portfolio earns 7% before expenses, a 0.20% expense ratio would leave about 6.80% before other costs and adjustments. A 0.70% expense ratio would leave about 6.30%. This is only an illustration and is not a return forecast.

Is Zerodha's 0.20% Expense Ratio Its Biggest Advantage?

Zerodha's base expense ratio of 0.20% is low for the category. This matters because arbitrage funds capture small spreads, leaving less room for high expenses.

However, cost is not a completely unique advantage. Other low cost arbitrage funds also operate near this level. Zerodha's fund should therefore be described as competitively priced, not automatically the cheapest or best.

Zerodha offers only a Direct Plan and Growth Option. This fits the fund house's direct and technology led distribution model, but it also means there is no Regular Plan for investors who prefer investing through a distributor.

As a new scheme, it has no meaningful performance history. Its low expense ratio is known, but investors still need time to assess execution quality, portfolio construction and return consistency.

Zerodha Arbitrage Fund vs Liquid Fund vs Fixed Deposit

If an investor has ₹1 lakh to park, the right choice cannot be decided only by looking at recent returns. The products work differently and carry different forms of risk.

A bank deposit is not market linked. Eligible deposits are insured by DICGC up to ₹5 lakh per depositor per bank, including principal and interest. A mutual fund does not receive this deposit insurance.

A liquid fund may be more appropriate when access speed and a very short holding period matter. An arbitrage fund may become more relevant when the holding period is longer, the exit load window can be crossed, and equity taxation has value for the investor.

Neither is automatically better. The comparison depends on liquidity, tax bracket, holding period, return certainty and comfort with NAV movement.

Why an Arbitrage Fund Is Not a Savings Account Replacement

Money needed for daily expenses or an immediate emergency should not automatically be moved into an arbitrage fund. Redemption is not the same as withdrawing cash from a bank account, and settlement may take two to three business days.

The Zerodha Arbitrage Fund also charges a 0.25% exit load on withdrawals within 30 days. Small NAV fluctuations can occur, especially over short periods. Therefore, investing for only a few days can produce an unfavourable outcome.

What Are the Risks of the Zerodha Arbitrage Fund?

Arbitrage funds are relatively low risk, but they are not risk free.

First, cash futures spreads can shrink. If many funds compete for the same opportunities, the returns available after expenses may fall.

Second, hedging reduces directional market risk but does not eliminate every risk. Liquidity problems, execution differences and sudden market disruptions can affect how efficiently positions are created or closed.

Third, the debt and money market portion carries credit and interest rate risk. The level of risk depends on the instruments and issuers held by the scheme.

Fourth, short term negative returns are possible. Transaction costs, temporary valuation changes, weak spreads and debt market movements can cause the NAV to decline over brief periods.

Finally, Zerodha's fund is new. It has not yet shown how consistently it can capture spreads across different market conditions.

Does an NFO NAV of ₹10 Make the Fund Cheaper?

No. The Zerodha Arbitrage Fund offered units at ₹10 during the NFO, but that does not make it cheaper than an older fund with an NAV of ₹20, ₹50 or ₹100.

NAV only shows the per unit value of a scheme's portfolio. A ₹1 lakh investment gets more units at a lower NAV and fewer units at a higher NAV, but the amount invested remains the same. Future returns depend on how the portfolio performs after investment, not on whether the starting NAV was ₹10.

Who May Find an Arbitrage Fund Useful?

An arbitrage fund may be relevant for investors parking surplus money for a few months or longer, who can accept small NAV movements and do not need a guaranteed return. It may also interest investors for whom the difference between equity and slab rate taxation is meaningful.

It may be unsuitable for people who need instant access to every rupee, expect equity like long term returns, require assured capital and returns, or plan to withdraw before the exit load period ends.

The category is meant for parking and stability, not long term wealth creation through equity market growth.

What Should Investors Check Before Choosing an Arbitrage Fund?

Investors should look beyond the highest one year return. Useful checks include the expense ratio, exit load, scheme AUM, consistency of returns, quality of the debt portfolio and the fund manager's experience.

They should also compare the scheme's returns with its benchmark and category peers over comparable periods. AUM can support efficient operations, but a larger fund is not automatically better because too much capital can also make it harder to find enough attractive arbitrage trades.

For a new fund, portfolio disclosures and execution become especially important because historical returns are not available.

What Makes the Zerodha Arbitrage Fund Different?

Structurally, the Zerodha Arbitrage Fund is similar to existing arbitrage funds. It uses cash and derivatives positions, maintains the equity allocation needed for the category, and invests the balance in short term debt and money market instruments.

Its clearest differentiators are a 0.20% base expense ratio and a Direct Plan only structure. These make it competitively priced and consistent with Zerodha Fund House's digital model, but they do not create a different return engine.

The fund's success will depend on execution rather than novelty. A familiar strategy at a low cost can be useful, but investors still need evidence that it can deliver consistent outcomes after expenses.

What Should Investors Watch After the Launch?

The most important figures to monitor are the actual portfolio, average hedged equity exposure, debt portfolio quality and changes in the expense ratio. Investors can also track one month and three month NAV behaviour, while recognising that such short periods are not enough to judge long term consistency.

Over time, the fund should be compared with the Nifty 50 Arbitrage Index TRI and established category peers. The relevant question is not whether it tops a return table in one month, but whether it captures available spreads efficiently without taking avoidable credit, liquidity or unhedged equity risk.

Conclusion

The Zerodha Arbitrage Fund enters a category that has expanded from about ₹90,746 crore in July 2023 to ₹2.91 lakh crore in July 2026. Its 0.20% base expense ratio and Direct Plan only format make it a low cost addition to the category.

However, the fund is not a guaranteed substitute for an FD, liquid fund or savings account. Returns are market linked, short term losses are possible, and the scheme has no established track record.

The launch deserves attention because arbitrage funds now occupy an important space between cash management and market linked investing. Whether Zerodha's fund stands out will become clearer only after it develops a portfolio and performance history across different market conditions.