I am thinking of using Arbitrage fund as a source of STP instead of a debt fund. If I invest in an Arbitrage fund for a year, there won't be any short-term gains and eventually no tax while switching.
It is a good idea to systematically transfer investments from an arbitrage fund into another fund. Their asset allocation makes them an ideal investment vehicle for those who would want the best of both worlds- safety like debt and tax-break of equity.
Arbitrage funds buy and sell an equity instrument simultaneously and profit from the difference in price. These funds take advantage of the mispricing between the cash and the derivatives market.
While they are classified as equity funds, giving investors the tax benefit of equity, arbitrage funds do have an exposure to debt. Their equity holdings are also hedged. Hence, the volatility associated with equity is missing. These funds go long in the cash market and short in the futures market. In this way, the fund manager hedges the risk. Hence, regardless of the market movement, the returns from arbitrage should always be in the green.
However, these funds can have a higher expense ratio because they resort to heavy trading. You can not expect mind boggling returns from such funds. But that is not its USP. Its appeal lies in the risk-free nature of its returns. Equity is the most efficient asset class for taxation benefits as dividend income and long-term capital gains, both are tax-free. From an investment point of view, equities are volatile in nature and the risk of capital erosion also exists. But arbitrage funds circumvent this problem.