Why income plus arbitrage funds are gaining popularity

The 2023 Budget reduced the appeal of debt funds.

The mutual fund industry is expanding its product line-up with fund houses introducing innovative solutions aimed at investors looking for tax-efficient alternatives to conventional debt funds. One such category is the income plus arbitrage funds.

Over the past six months, many fund houses such as Aditya Birla Sun Life, HDFC, Kotak Mahindra, HSBC and Bandhan have repackaged existing schemes, while others such as Baroda BNP Paribas, Tata, Union, UTI and SBI have launched or are in the process of launching funds that combine debt and arbitrage strategies.

Data available with ACE MF, a mutual fund research platform, shows that the assets under management (AUM) under this category have surged from Rs 743 crore as of April 2023 to Rs 3,161 crore as of April 2025.

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What exactly are these funds, how do they function, and could they serve as an alternative to traditional debt funds?

Funds structure

Income Plus Arbitrage Funds are hybrid mutual funds that combine arbitrage opportunities in equities -- low-risk profit from price differences between the cash and derivatives markets, debt instruments such as bonds, treasury bills and commercial paper for stable income.

In arbitrage, funds buy shares in the cash market and at the same time sell them in the futures market. The difference in prices is pocketed at the time of expiry by reversing the positions. In the long term, the returns generated by these funds typically track the yields on the instruments in the money market.

The portfolio split of these funds is typically 65 percent in arbitrage (equity + derivatives) to qualify as equity-oriented for tax purposes and 35 percent in debt instruments to provide predictable returns.

The objective of these funds is to deliver better returns than traditional liquid or short-term debt funds, but with equity-like tax treatment (especially for short-term investors).

Why the pivot?

This year, Aditya Birla Sun Life Active Debt Multi Manager FoF was changed to Aditya Birla Sun Life Debt Plus Arbitrage FOF, Bandhan All Seasons Bond Fund became Bandhan Income Plus Arbitrage Fund of Funds, HSBC Managed Solutions India Growth Fund was renamed as HSBC Aggressive Hybrid Active FOF, while Kotak All Weather Debt FOF was repackaged to Kotak Income Plus Arbitrage FOF.

Financial experts observe that these developments highlight asset managers' efforts to adapt to the evolving investment environment and policy changes on the taxation front.

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The 2023 Budget reduced the appeal of debt funds by taxing their gains at the investor’s income tax slab rate. For those in the highest bracket, this means paying up to 30 percent tax on returns from debt funds.

Fund of Funds (FoFs) got a tax boost the following year—if held for over two years, their gains are taxed at just 12.5 percent as long-term capital gains. However, to qualify, FoFs must limit their debt exposure to 65 percent or less.

The repackaging of existing debt to income plus arbitrage category funds or new fund launches is a response to investors wanting debt-like risk with better tax efficiency.

Factors to keep in mind

Advisors say hybrid FoFs may offer more predictable returns than pure arbitrage funds, thanks to their debt-arbitrage mix, along with improved long-term tax benefits under the new rules.

These funds provide flexibility to fund managers as they can dynamically adjust between arbitrage and fixed income based on market conditions. Further, these funds are alternatives to liquid and arbitrage funds as they offer a middle ground – better returns than arbitrage and lower volatility than equity.

The arbitrage component can potentially enhance returns while maintaining a relatively conservative risk profile. Additionally, the FoF structure enables fund managers to shift between debt and arbitrage allocations tactically, without creating taxable events for investors.

Can they replace debt funds?

According to Viral Bhatt, Founder, Money Mantra, income plus arbitrage funds cannot replace debt funds for all investors. “These funds offer better post-tax returns in many cases, but they have a slightly more complex structure than traditional debt funds. Further, returns depend on arbitrage opportunities and debt market stability,” said Bhatt.

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These funds are ideal for conservative investors looking for low-risk, tax-efficient alternatives to debt funds with short-to-medium term goals of at least six months to three years.

“Income Plus Arbitrage Funds are emerging as a tax-smart, stable alternative to debt funds. While they won’t fully replace traditional debt products, they are becoming a popular option in the post-2023 taxation era, especially for investors with short-term horizons and tax sensitivity,” said Bhatt.