Are you looking for a low-risk investment option in India that offers better tax efficiency than traditional debt funds?
Arbitrage funds present a unique investment opportunity for conservative investors seeking equity taxation with relatively lower risk. They can be a suitable alternative to liquid funds, especially in volatile markets, while offering potential tax efficiency under short-term capital gains.
An arbitrage fund is a type of equity mutual fund that invests at least 65% of its assets in equity and equity-related securities. The fund manager simultaneously buys and sells the same security across different markets to capture price differences. This approach creates a 100% hedged investment strategy, which effectively eliminates price volatility risk.
If you want to understand how arbitrage funds work and whether they suit your investment goals as an NRI, this guide explains everything you need to know.
How Do Arbitrage Funds Work For NRIs?
An arbitrage fund operates differently from traditional mutual funds. Instead of buying stocks and hoping for price appreciation, these funds profit from price differences of the same asset across different markets.
The fund manager exploits market inefficiencies by simultaneously buying a security in one market at a lower price and selling it in another market at a higher price. This strategy focuses on the price difference between two primary markets: the cash (spot) market and the futures market.
The cash market involves immediate transactions at current market prices. The futures market deals with contracts for future delivery at predetermined prices. When a price gap exists between these markets, arbitrage funds capture these risk-free profits.
To qualify as equity funds for tax purposes, arbitrage funds must invest at least 65% of their assets in equities and equity-related instruments. The remaining 35% typically goes into debt securities and money market instruments, providing stability when arbitrage opportunities are limited.
Key Reasons NRIs Should Consider Arbitrage Mutual Funds
Arbitrage funds are a smart choice for NRIs, especially after the 2023 budget changes that made debt funds less tax-efficient by taxing them at slab rates. In contrast, arbitrage funds still enjoy equity-like taxation, with 20% on short-term gains and 12.5% percent on long-term gains over ₹1.25 lakh, making them more attractive for NRIs in higher tax brackets.
These funds are also relatively low risk. Fund managers lock in profits by buying and selling securities simultaneously in cash and futures markets. This structure makes them less dependent on market trends and is ideal for NRIs who cannot monitor markets frequently.
In fact, market volatility benefits arbitrage funds, as wider price gaps between cash and futures create more profit opportunities. Despite fluctuations, these funds have historically delivered stable returns around 5 to 6 percent annually, even during downturns.
They also offer liquidity and flexibility. While holding them for over 12 months gives better tax treatment, you are not tied down like with fixed deposits or long-term debt options.
For NRIs looking for a low-volatility, tax-efficient alternative to fixed deposits, arbitrage funds provide a good balance of safety, predictability, and potential for better returns.
Step-by-Step Guide for NRIs to Invest in Arbitrage Funds in India
As an NRI, you need to set up the proper banking infrastructure before investing in arbitrage funds. The process differs slightly from resident investments but remains straightforward once you understand the requirements.
Step 1: Open the Right Bank Account
You need one of these two account types to invest in arbitrage funds:
- Non-Resident External (NRE) Account: For investments you wish to repatriate back to your country of residence
- Non-Resident Ordinary (NRO) Account: For investments that will remain in India (non-repatriable)
Step 2: Complete Your KYC Process
You must complete your NRI KYC (Know Your Customer) verification before making any investments. The required documents include:
- PAN Number
- Overseas address proof (utility bill, rent agreement, driving license)
- Passport (front and back)
- Passport-sized photograph
- Signature specimen
Step 3: Complete the Onboarding Process
Once your KYC is approved (typically within 7-8 business days), you need to provide:
- City and country of birth
- NRE/NRO bank account statement or canceled cheque (from the past 3 months)
- Nominee details
Step 4: Start Investing
You can now invest in the best arbitrage funds. These funds offer a unique combination of equity-like tax benefits and debt-like stability.
Conclusion
Arbitrage funds provide NRIs with a unique mix of equity-like tax benefits and debt-like stability. By capitalizing on price differences between the cash and futures markets, these funds generate low-risk returns while avoiding direct exposure to market volatility.
Their biggest advantage lies in tax efficiency. Short-term gains are taxed at 20%, and long-term gains above ₹1.25 Lakhs are taxed at 12.5%, unlike debt funds, which are taxed at slab rates. This makes them especially suitable for NRIs in higher tax brackets.
Market volatility enhances their return potential by widening arbitrage opportunities. They also offer liquidity and flexibility, making them a compelling alternative to fixed deposits.
For NRIs seeking a low-risk, tax-efficient option for short to medium-term goals, arbitrage funds offer a well-balanced solution. However, it is recommended to consult a financial advisor to ensure they align with your overall investment strategy.
Frequently Asked Questions
Q1. What are arbitrage funds, and how do they work in India?
Arbitrage funds are hybrid mutual funds that aim to generate low-risk returns by exploiting price differences between cash and futures markets. Fund managers simultaneously buy stocks in one market at a lower price and sell them in another at a higher price, capturing the price spread while minimizing risk.
Q2. Are arbitrage funds a good investment option for NRIs?
Yes, arbitrage funds can be an excellent choice for NRIs. They offer tax efficiency, stability, and potential for slightly higher returns than traditional fixed deposits. These funds are particularly beneficial for NRIs in higher tax brackets who seek a balance between safety and returns in their Indian investment portfolio.
Q3. How are arbitrage funds taxed for NRI investors?
Arbitrage funds enjoy favorable tax treatment in India. Short-term capital gains (held less than 12 months) are taxed at 20%, while long-term gains benefit from a ₹1.25 lakh annual exemption, with amounts exceeding this threshold taxed at 12.5%. This makes them more tax-efficient compared to many other investment options.
Q4. What documents do NRIs need to invest in arbitrage funds in India?
NRIs need to complete their KYC (Know Your Customer) process by submitting documents such as PAN Number, overseas address proof, passport copy, photograph, and signature specimen. They also need to have either a Non-Resident External (NRE) or Non-Resident Ordinary (NRO) account to invest in these funds.
Q5. How do market conditions affect the performance of arbitrage funds?
Arbitrage funds tend to perform well during volatile market conditions when price discrepancies between cash and futures markets are more frequent. In stable markets, they generally deliver returns comparable to liquid funds. Their fully hedged approach helps minimize risk from market fluctuations, making them a relatively stable investment option.
