Arbitrage Funds are referred as equity-and-derivative funds. The objective of an arbitrage fund is to capitalise on a stock's price difference between the spot market (cash segment) and the derivatives market (futures & options segment). These funds basically generate income by taking advantage of the arbitrage opportunities arising out of the mis-pricing between the two markets (spot and derivative).
If a stock A has a spot price of 100 and future price of 110, then an arbitrage fund manager sells the stock futures at 110 and buys the stock in spot market for Rs 100 and earns Rs 10 for the stock.
Furthermore, on the settlement day of the derivatives segment, the stock prices in both the markets tend to coincide. So, the fund manager will reverse his transaction - buy a contract in the futures market and sell off his equity holdings in the spot markets - and earn more profits.
Arbitrage funds offer better returns than debt or income funds and their earnings become tax-free after a year. However the concern is if the size of the fund is very large, most of the money would be parked in money market instruments.
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