How exactly do arbitrage funds operate?

To understand arbitrage funds, you first need to understand arbitrage as a strategy. Arbitrage is the process of identifying and locking in a price differential. Let us assume that Reliance share is quoting at Rs.900, while the Reliance Futures expiring in 1 month is available at Rs.910. This is an arbitrage opportunity. If you buy the Reliance equity share at Rs.900 and sell the Reliance Future at Rs.910, then you can lock in a profit of Rs.10 for the month. This is risk-free profit as on the last Thursday of the month when the Futures contract expires, the cash price and the futures price will be the same. Now Rs.10 on Rs.900 works out to 1.11% for one month and nearly Rs.13.2% annualised. You may believe that 13.2% returns is an attractive return on an arbitrage fund. But in reality, an arbitrage fund will face a variety of challenges through the year and hence the actual returns will never be so high.