Filling the Blanks: SEBI’s Consultation Paper on the New Asset Class

By Ayush Mhatre and Soumya Deouskar

India’s investment landscape has suffered from a significant gap between the retail-oriented Mutual Fund (“MF”) investments on the one hand, and the more exclusive Portfolio Management Services (“PMS”) or Alternate Investment Funds (“AIFs”) on the other. The gap lies in the disparity of the entry-level ticket size required for MF, which is extremely low, and PMS, which is extremely high. As a result, a large segment of investors who desire mid-level sophisticated investment strategies remain largely untapped by the market. There is evidence to show that such investors are attracted towards unregulated investment products offered by unregistered entities. For instance, SEBI recently levied penalties on ‘Bear2Bulls’, a fraudulent financial service provider that collected substantial unauthorized funds via unregistered investment schemes.

To counter this, the Securities and Exchange Board of India (“SEBI”) has introduced a consultation paper proposing a New Asset Class (“NAC”) to close the chasm between MF schemes and PMS investments. This post attempts to highlight the key proposals of the paper, analyse the implications and potential challenges to the proposed NAC, and recommend measures to counter the same. 

Highlights of the Consultation Paper

Breaking the Glass Ceiling: NAC

Traditionally, MF products are availed by retail investors with a low-risk appetite. While MF investments can begin at Rs. 500, or even Rs. 100 in the case of some Systematic Investment Plans (“SIPs”), PMS investment approaches give the ‘high risk, high return’ element to the portfolio - with the caveat of a prohibitive entry-barrier of Rs. 50 Lakhs. Practically, even breaching the entry barrier is insufficient for an investor, as only a much larger purse (of around 2/2.5 Crores) is well suited to invest in this category. This creates a glass ceiling for retail investors. AIFs, regulated by the SEBI (Alternative Investment Funds) Regulations, 2012 face a similar difficulty with an entry barrier of Rs. 1 crore.

Given this void, the consultation paper aims to develop a framework for a regulated investment product with a higher risk appetite and a higher ticket size in comparison to MFs, but with a less prohibitive entry barrier in comparison to PMS or AIFs. It proposes a minimum investment of Rs. 10 Lakhs per investor across all strategies offered by an Asset Management Company (“AMC”) under NAC. It also proposes relaxations on investments in the NACs, in comparison to the existing regulations for MF. These relaxations include an increase in the credit risk for a single issuer from 10% to 20%, indicating the risk-friendly nature of the NAC.

NAC: The Bright Side

Some key features of NAC stand out as favourable. Firstly, NAC is proposed to be offered under the mutual funds umbrella in a pooled fund structure. This means that from an investor point of view, NAC would be accessible with the convenience of a pre-existing MF platform, and various investment strategies such as SIP, Systematic Withdrawal Plan (SWP), and Systematic Transfer Plan (STP) would be available under NAC. In fact, this can lead to AMCs exploring cross-selling strategies between MFs and the NAC, leveraging their existing customer base and giving way for potential growth. This means that the NAC could indirectly create opportunities for MF schemes to expand into unexplored market segments by offering additional products. In this context, the paper also notes that to avoid confusion among investors, strategies under NAC would have distinct branding and advertisements differentiating its higher risk profile from MF schemes.

Secondly, NAC would be allowed to use derivatives such as stocks, bonds, etc. for non-hedging (or speculative investments) too. Neither MFs nor PMS are allowed to use derivatives in this manner by SEBI. This opens the door on a new set of products, two of which find mention in the paper.

i. Long-short equity Fund: These funds are designed to maximize the upside of markets while limiting the downside risk. For example, such funds may hold undervalued stocks that the fund managers think will rise in price, while simultaneously short-selling overvalued stocks in an attempt to reduce losses. A major upside to this is that because long/short strategies do not depend heavily on upward markets, there is potential for returns from both increasing and decreasing prices.

ii. Inverse ETF/Fund: An inverse ETF mimics the underlying index's return by using financial derivatives like swaps, options, and futures contracts. To maintain the appropriate exposure to the index, the fund management buys and sells derivatives contracts daily. For instance, an inverse ETF that tracks the Sensex index will rise by 2% if the Sensex index's value decreases by 2%. In a similar vein, the inverse ETF will fall by 2% for every 2% increase in the Sensex. Thus, inverse ETFs allow investors to profit from, or protect their portfolios against downward movements in the market or specific sectors. This can be particularly useful during periods of market uncertainty or economic downturns.

Moreover, to protect investors from market volatility, the proposed NAC framework imposes strict investment limits. It caps the high-risk equity and equity-linked investments at 15% of the NAC's net asset value (NAV). Further, to balance equity investments with relatively stable debt instruments, it has raised the sectoral limit for investments in debt securities from 20% to 25%.

Finally, a monthly portfolio disclosure requirement has also been suggested. This feature is similar to the disclosure requirements of MFs for greater transparency. Consequently, a combination of these features is expected to enable investment flexibility for the investors.

The Flipside: Potential Challenges and Recommendations

The success of this move will depend on striking the right balance between increased flexibility and investor protection. Accordingly, some concerns will have to be addressed going forward with implementing the NAC.

Firstly, the eligibility criteria for offering NAC are problematic. It is observed that the existing MF or AMC with a strong track record of Asset Under Management (“AUM”) of Rs. 10,000 crores for the past three years can offer the product. Alternatively, AMCs with a Chief Investment Officer, with experience of 10 years and Additional Fund Manager with experience of 7 years, along with managing AUM of not less than Rs. 5,000 crores and managing AUM of not less than Rs. 3,000 crores, respectively, shall be eligible. While the eligibility criteria include AUM requirements and a history of compliance, there can be other considerations to strengthen this scheme. For instance, if the objective of NAC is to reduce unregulated investment strategies and protect investors from unrealistic risks, then the fund performance must be a matter of considered importance. It has been noted that a higher AUM does not necessarily translate into financial success or risk aversion. For instance, a strong track record has been given importance in Section 7(a) of the SEBI Mutual Fund Regulations, 1996 wherein the sponsor should have a sound track record and general reputation of fairness and integrity in all his business transactions to be eligible for registration. Therefore, some consideration for the historical performance of the AMC may be essential for strengthening the eligibility criteria.

Moreover, the eligibility is also limited only to Asset Management Companies (AMCs), which directly excludes PMS providers or AIF investment professionals/wealth managers. A broader and more inclusive eligibility criteria may, primarily, cover a broad range of experts and managers bringing innovation to the table, and secondarily increase competitiveness in the market, which may subsequently result in lower costs for the investors.

Secondly, introducing complex strategies at a lower entry point raises questions about investor suitability and risk management. In practical terms, since inverse ETFs provide returns on the downward movement of the market daily, they cannot be long-term investments due to the inherent upward-looking direction of the market, regardless of their short-term rise and fall.[1] Therefore, holding inverse ETFs may prove to lose its value over time. Similarly, in the case of long-short equity, the flexibility that this product offers may turn on its head if the investor holds a long position when the market goes down and a short position when the market shoots up. It is doubtful whether this will fare well for non-professional retail investors. 

Therefore, if the aim is to draw more retail investors to NAC, sufficient foresight to address these issues would be required. A gradual, phased roll-out of NAC may be a potential solution to this. It would allow AMCs to adjust and build the necessary infrastructure to facilitate NAC’s integration into the market. Moreover, the alignment of regulatory frameworks, reporting standards, and risk management practices across investment vehicles could bolster the integration. 

Finally, there is also an urgent need to address the confusion surrounding the tax implications of the NAC. Currently MFs, unlike PMSes, have pass-through status, which does not obligate a business to pay corporation tax, which makes it favourable by avoiding double taxation. Although it is expected that the NAC will be a tax-efficient product similar to MFs, the paper remains ambiguous on this point. Hence, the tax regime for NAC would also influence its popularity amongst investors.

Conclusion

The proposed NAC, if implemented right, paves the way for a more diverse and sophisticated investment landscape in India. A good starting point for the right implementation would be a more inclusive eligibility criteria for offering NAC, to include wealth managers apart from AMCs. The expertise of such professionals may also help to tackle the high-risk element of the product. Similarly, a gradual and more cautious roll out of NAC may also help with tackling the high risk. Once these roadblocks are addressed, NAC could ultimately empower a larger pool of capital to access more regulated investment. As SEBI refines its proposal based on industry feedback, the coming months will be crucial in shaping the future of this innovative asset class.

[1] David Romer, Keynesian Macroeconomics Without the LM Curve, 14 J. of Eco. Perspect. 166, 149-169 (2000).

Disclaimer

The views expressed in this article are solely those of the author(s). This article is intended for educational/information purposes only. The source of this article is publicly available information and under no circumstances should the contents of the article be construed to be professional advice by the authors.