Equity Long Short Funds vs. Arbitrage Funds: Choosing Your Investment

On February 27, 2025, SEBI issued a circular for launching of  Specialised Investment Fund (SIF) (vide circular no. SEBI/HO/IMD/IMD-PoD-1/P/CIR/2025/26), which is a new investment vehicle that tries to combine features of mutual funds and portfolio management services (PMS). 

SIFs are permitted to adopt a range of “sophisticated investment strategies” across equity, debt, and hybrid categories. Within the equity category, one such investment strategy is the “Equity Long-Short Fund”. 

As per SEBI guidelines, an Equity long short fund invests at least 80% of its total assets in equity and equity-related instruments. The fund can maintain a maximum “short exposure” of 25% through unhedged derivative positions in equity and equity-related instruments. 

Furthermore, investors may note that SIFs contain a minimum investment threshold. The minimum aggregate investment by an investor across all investment strategies offered by the SIF,  at the Permanent  Account  Number (‘PAN’) level, should not be less than ₹10 lakhs. 
 

An arbitrage fund is a hybrid mutual fund scheme following the “arbitrage strategy”. As per SEBI regulations, it invests at least 65% of its total assets in equity and equity-related instruments. However, its “net equity exposure” could be lower than 65% due to hedged arbitrage positions.

Next, it is worth mentioning that if the fund manager of an arbitrage fund cannot find arbitrage opportunities in the market, the scheme may temporarily make “defensive investments” where it allocates assets to low-risk debt instruments. The exact asset allocation that the fund will follow in such situations must be disclosed in the Scheme Information Document (SID).

At the same time, SEBI has restricted the debt portion of the portfolio to CDs, government securities with maturity of upto 1 year, mutual fund units of liquid, money market or schemes having Macaulay duration less than 1 year for meeting liquidity and margin requirements. This restriction may prevent arbitrage mutual funds from taking additional credit or duration risk through corporate bonds or long-term debt securities.
 

While both Equity Long Short Funds and Arbitrage Funds use derivatives and can take hedged positions, their investment objectives are fundamentally different. 

• Arbitrage funds aim to capture price differences between cash and derivatives markets. 

• In contrast, Equity long short funds aim to generate returns by taking:

• Long positions in stocks potentially expected to outperform and

• Short positions (upto 25%) in stocks expected to underperform

To further enhance our understanding, let’s check out the detailed comparison below:

Choosing between an Equity Long Short Fund and an Arbitrage Fund is not only about returns offered by them. Instead, the “right” choice depends on your:

• Investment objective

• Risk appetite, and

• Market outlook

While both strategies use derivatives + hedging techniques, they are designed to achieve very different outcomes. 

• An equity long short fund aims to generate potential “alpha” by taking both long and short positions (upto 25%) in stocks.

• In contrast, an arbitrage fund aims to capture price differences between the cash and derivatives markets through hedged positions.

Thus, long short funds might suit investors who are comfortable with relatively higher risk in pursuit of potentially higher returns. At the same time, an arbitrage fund can be considered a comparatively “conservative option”. It might suit low-risk appetite investors seeking relatively stable potential returns with lower market risk.

For more clarity, let’s study the table below:

So, now you know what equity long short funds and arbitrage funds are and how they differ. While both investment strategies use derivatives and can take hedged positions, they are built for different purposes.

An equity long short fund may aim to generate potential returns by taking long positions in stocks expected to outperform and short positions (upto 25%) in stocks expected to underperform. In contrast, an arbitrage fund may aims to capture price differences between the cash and derivatives markets to earn potential returns (through hedged trades).

The “right” choice? It depends on your risk appetite, investment horizon, and financial objectives. You may consider an equity long short fund if:

• You have a relatively higher risk tolerance.

• You seek potentially higher returns through active stock selection.

• You aim to get exposure to both rising and falling market opportunities.

• You are comfortable with sophisticated investment strategies involving derivatives.

• You can meet the SIF minimum investment requirement of ₹10 lakh (checked at the PAN level across all the permitted SIF strategies with one AMC).

In contrast, you may consider an arbitrage mutual fund if your priority is relatively lower market risk and more stable return potential. It may also suit investors looking for a "hedged equity-oriented" strategy that primarily exploits pricing inefficiencies rather than directional market movements.

1. What is an arbitrage strategy followed by an arbitrage fund?

An arbitrage strategy aims to earn potential returns by exploiting temporary price differences between the cash and derivatives markets. For example, 

• Suppose a stock is trading at ₹1,000 in the cash market and ₹1,015 in the futures market,

• Now, the arbitrage fund may buy the stock in the cash market and simultaneously sell it in the futures market. 

• As the prices “converge” at expiry, the fund may realise the price difference as a relatively low-risk return.
   

2. Which is riskier: an Equity Long Short Mutual Fund or an Arbitrage Fund?

As per general market understanding, an equity long short mutual fund may carry relatively higher risk. That’s because it actively takes long and short positions based on the fund manager's market view. 

In comparison, arbitrage mutual funds primarily use hedged positions to capture price differences. This investment strategy may result in comparatively lower market risk.
 

3. Why do arbitrage funds invest in debt instruments at times?

When sufficient arbitrage opportunities are “unavailable”, arbitrage mutual funds may temporarily allocate their assets to low-risk debt instruments. As per SEBI regulations, such investments are restricted to CDs, government securities with maturity of upto 1 year, mutual fund units of liquid, money market or schemes having Macaulay duration less than 1 year for meeting liquidity and margin requirements.