Arbitrage Fund Returns Set to Shrink as Government Raises Trading Tax

Investors in popular arbitrage mutual funds are bracing for a dip in returns. A key budget proposal from the government is poised to squeeze the profits of these funds, which have become a favorite tool for affluent and tax-savvy investors. The change centers on an increase in the securities transaction tax, commonly known as STT.

Understanding the STT Increase and Its Direct Impact

The government’s recent budget includes a proposal to raise the securities transaction tax on the sale of futures contracts. This is a direct cost levied on specific financial transactions. For arbitrage funds, which rely heavily on trading in futures and other derivatives, this higher tax acts like an additional toll on their primary highway of operation.

Analysts estimate that this STT hike will reduce the net returns generated by arbitrage funds by approximately 25 to 35 basis points. One basis point is one-hundredth of a percentage point. While this may seem like a small figure, in the world of arbitrage where margins are typically thin and consistent, this represents a meaningful headwind. It directly eats into the price anomalies, or tiny temporary mispricings between markets, that these funds seek to exploit for profit.

Why Arbitrage Funds Remain Popular Despite the Squeeze

Despite this expected compression in returns, financial advisors do not anticipate a mass exodus from arbitrage funds. The primary reason is their unique tax efficiency. Returns from arbitrage funds are treated as capital gains from equity-oriented funds for tax purposes.

This means that for investments held for over one year, the gains are classified as long-term capital gains, which are currently tax-free up to a limit of one lakh rupees annually. Gains beyond that are taxed at only 10%. For holdings shorter than one year, short-term capital gains are taxed at 15%. This structure is significantly more favorable than the tax treatment for fixed deposits or debt funds, where returns are added to an investor’s income and taxed at their applicable slab rate, which can be as high as 30% or more.

For high-net-worth individuals in the top tax brackets, this tax advantage often outweighs a modest decline in pre-tax returns. The funds are also perceived as a relatively low-volatility parking place for large sums of cash, offering returns that are generally superior to savings accounts while maintaining high liquidity.

The Broader Context for Investors

This development serves as a reminder that regulatory and tax changes are a constant factor in the investment landscape. The government’s move appears aimed at increasing revenue from the booming derivatives market. For investors, it underscores the importance of looking at net returns after all costs and taxes, not just the headline yield.

While the STT increase is a setback, the structural appeal of arbitrage funds remains intact for a specific investor profile. They continue to offer a tax-efficient solution for managing short-to-medium-term capital with lower risk compared to direct equity investment. However, investors should recalibrate their return expectations downward and consult with their financial advisors to ensure these funds still align with their goals in this new cost environment.