The Sensex is well above 15,000 points. And there is clear consensus among experts that that whether the market goes up or down, there will be a serious element of volatility in the days to come.

A question that many investors who have already sold and booked profits are facing is what they should do with the excess cash that they have. The options aren't too many.

One could plough the money back into stocks, but the element of volatility may dissuade many from doing so. At the same time, locking funds in the debt market, be it income funds or longer tenure deposits, is also not very smart, as one does not know how the stock market may behave.

So the options in such a case are short-term debt products such as fixed maturity plans (FMP), short-term bond funds, bank fixed deposits or liquid funds. Another interesting option is arbitrage funds.

Investors, who are not familiar with arbitrage funds might just end up thinking that these are equity-oriented schemes with another fancy name. However, that is not the case.

What such funds aim to do is to take advantage of the arbitrage opportunities between the cash and the futures market to generate fixed income.

The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market. Nowadays, these funds have sophisticated software products that flag such mispricing, the moment it occurs. Let's understand how this works.

Suppose the stock price of ABC is quoting at Rs 60. Let's say the stock is also traded in derivatives segment, where its future price is Rs 61. In such a case, one can make a risk-free profit by selling a futures contract of ABC at Rs 61 and buying an equivalent number of shares in the cash market at Rs 60.

On settlement day, the price of the equity shares and their stock futures will converge to the same price, so the fund can reverse its position, that is, sell in the cash market and buy in the future market.

Thus, it wouldn't matter which direction the stock price took in the interim period. In other words, it is irrelevant whether the share price of ABC has risen or fallen, one would still make the same amount of money.

So four transactions have taken place:

• Buying of stock
• Selling of futures
• Selling of stock
• Buying of futures

In this manner, irrespective of the share price, the investor (the fund in this case) earns the spread between the purchase price of the equity shares and the sale price of futures contract.

After all, the problem that most investors have with entering into the equity market is the lack of assured risk-free returns. And this product does just that. One can invest any time without any entry load but for redemptions before six months, there is an exit load of 0.35 per cent. There is no exit load after this period.

Let us compare the after tax returns of this with other short-term products available in the market (See Post -Tax Returns).

Arbitrage funds currently are giving around 8.5 per cent per annum. Also, increasing volatility in the market is likely to increase the chances of mispricing. Therefore, the returns could be higher as well. So it is expected that at this level of market volatility on either side, arbitrage funds are likely to benefit.

For taxation purposes, arbitrage funds are identified as equity funds, which is a big advantage for investors. Hence, the short-term capital gains tax is 10 per cent and there is no long term capital gain, if one stays invested for more than a year. Dividends are also tax-free without any dividend distribution tax.

On the other hand, in the case of non-equity mutual funds, dividends are subject to a distribution tax of 15 per cent. If one chooses the growth option in a non-equity fund, and is invested for less than a year, short-term capital gains tax would be applicable which would be as per the tax slab of the individual.

Similarly, for over one year, long-term capital gains taxes are at the rate of 10 per cent or 20 per cent with indexation. Thus, arbitrage funds are more tax efficient than debt funds or monthly income plans.

The post-tax returns in the arbitrage fund are superior to  fixed maturity plans, bank fixed deposits, income funds, liquid fund schemes and savings bank accounts. Investors wanting a breather from the equity market and for those looking for safe fixed income should invest in arbitrage funds.

However, if the fund manager is not able to find enough arbitrage opportunities, the returns will fall. That is the risk element in these funds.