Whalesbook
Arbitrage Strategy Under Pressure
The significant increase in Securities Transaction Tax (STT) levied on futures and options (F&O) trades is poised to diminish the returns generated by arbitrage funds. These funds, a favored vehicle for investors parking surplus cash, operate by exploiting minute price discrepancies between the cash and derivatives markets. The heavy reliance on F&O transactions means any hike in STT directly erodes their profitability. Industry analysts anticipate a tangible impact, forecasting a decline of 30 to 50 basis points in returns once the new tax regime takes effect from the commencement of the next fiscal year.
Asset Growth Faces Headwinds
Arbitrage funds have witnessed substantial growth in recent years, particularly following the tax regime changes for debt funds in 2023. Assets under management for this category have surged dramatically, nearly quadrupling to ₹2.8 trillion between January 2023 and December 2025. Deepak Shenoy, CEO of Capitalmind Asset Management, noted that arbitrage funds are significant players in futures trading and will likely see their returns decrease by approximately 0.5% due to the STT increase. An analysis by Edelweiss MF further quantified this, suggesting a potential annualised reduction of 0.32 percentage points from arbitrage fund returns, assuming an average 70% exposure to arbitrage strategies.
The Tax Advantage Remains
Despite the anticipated reduction in returns, arbitrage funds may continue to hold an advantage over traditional liquid funds. Their taxation structure, which classifies them under equity taxation (12.5% if held for over a year), remains more favorable than the slab-rate taxation applicable to debt funds, which can exceed 30%. Vivek Rajaraman, Managing Director and Head of Client Advisory at Waterfield Advisors, pointed out that while the reduced returns might dent their appeal, the net tax benefit compared to other short-term parking options like liquid or ultra-short duration funds will likely keep them competitive. This suggests investors might not shift away immediately, though consideration of alternative asset classes could grow.
Broader Market Implications
The STT revision is not limited to pure arbitrage funds. Other hybrid schemes that incorporate arbitrage strategies, such as equity savings funds and certain multi-asset allocation funds, will also experience an impact. Furthermore, many specialised investment funds (SIFs), a relatively new segment within mutual funds, are expected to feel the effect of the higher STT on their F&O exposures.