An arbitrage fund earns the price gap between a share in the cash market and its futures contract, with returns close to short-term interest rates.
An arbitrage fund buys a share in the cash market and, at the same time, sells a futures contract on the same share. At the futures expiry the two prices meet, so the fund keeps the gap it locked in, whichever way the share moved.
For example, a share trades at ₹1,000 and its month-end future at ₹1,007. The fund buys the share and sells the future. At expiry it earns ₹7, or 0.7% for the month, before costs.
The gaps depend on market conditions, so returns vary from month to month. They have usually been close to short-term interest rates. The fund keeps the rest of its money in debt and money-market holdings. SEBI counts it as a kind of hybrid fund.
Because at least 65% of the fund is in Indian shares, it is taxed as an equity fund: 20% on gains from units held 12 months or less, and 12.5% on long-term gains above ₹1.25 lakh a year. See STCG and LTCG.
Arbitrage funds trade constantly, so their portfolio turnover is high. Many charge an exit load on redemptions within a month or so of buying.
Each fund page has its returns, risk, costs, managers and everything it holds.