Budget 2026 STT Increase: Implications for Arbitrage and Investment Funds
Finance Minister Nirmala Sitharaman's Budget 2026 proposal to raise the securities transaction tax (STT) on futures and options trades has significant implications for arbitrage funds and other investment vehicles. While the absolute increase appears modest, its material impact on funds relying on cash-futures spreads cannot be overlooked.
Understanding the STT Hike Details
In her Sunday Budget speech, Sitharaman announced specific increases: the tax for futures will rise from 0.02% to 0.05%, while options premiums and exercised options will see taxes increase to 0.15% from previous rates of 0.10% and 0.125% respectively. This adjustment directly affects transaction costs in India's derivatives market.
Arbitrage Funds: The Primary Impact Zone
Arbitrage funds operate by purchasing shares in the cash market while simultaneously selling futures to capture price differentials. These positions require frequent rollovers and are executed in substantial volumes, making them particularly sensitive to transaction cost changes.
According to Edelweiss Mutual Fund estimates, the higher STT could reduce arbitrage fund returns by approximately 0.32% annually. This calculation assumes average arbitrage exposure around 70% with portfolio churn of roughly 20%.
Radhika Gupta, Managing Director and CEO of Edelweiss Mutual Fund, explained: "The increase in STT on F&O trades is expected to impact arbitrage fund returns by roughly 30 basis points on an annualized basis. Even after this adjustment, arbitrage funds remain attractive compared to liquid and other short-term debt funds."
Comparative Returns Analysis
The tax efficiency advantage of arbitrage funds faces compression due to the STT hike. With liquid funds potentially delivering around 7% returns, the post-tax return difference between arbitrage and liquid funds could narrow from approximately 1.23% to about 0.90%.
This narrowing occurs despite arbitrage funds' favorable tax treatment: they attract just 12.5% long-term capital gains tax when held over a year, compared to liquid funds where capital gains are taxed at the investor's income tax slab rate (with the highest marginal rate at 30%).
Anup Bhaiya, founder of Money Honey Financial Services, noted: "The increase in F&O STT rates will narrow the yield advantage of arbitrage funds over liquid and ultra-short funds. However, arbitrage funds remain a low-volatility and tax-efficient alternative for investors."
Impact on Other Fund Categories
- Multi-Asset Allocation Funds: These funds experience smaller impacts due to lower arbitrage exposure (typically around 25%) and greater reliance on directional equity, debt, and other strategies. Edelweiss estimates approximately 0.08% annual impact for its multi-asset allocation fund.
- Equity Savings Funds: These will be affected proportionally to their allocation to F&O instruments.
- Specialized Investment Funds (SIFs): As a newer product category permitted to use F&O for hedging and short positions, SIFs face impacts based on their F&O exposure. The effect varies significantly; for instance, Altiva Hybrid Long Short Fund expects only about 5 basis points impact.
Market Context and Broader Implications
The STT increase occurs alongside broader market reactions to Budget 2026, including concerns about derivatives trading volumes. While arbitrage funds face the most direct consequences, the overall investment landscape adjusts to these revised transaction costs.
Investment professionals emphasize that despite the return compression, arbitrage funds maintain their position as viable options for investors seeking tax efficiency with lower volatility compared to pure equity investments.
