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The post is authored by Jatin Yadav and Kartik Mehta, fourth-year student of B.A. LL.B (Hons.) at the Hidayatullah National Law University, Raipur.
1.INTRODUCTION
Underlining the growing participation of retail investors in long-term investment strategies, the Indian mutual fund market has observed a fivefold expansion over the last ten years. The same is evident in the significant surge in new mutual fund issuers. According to the Securities and Exchange Board of India (“SEBI”) (Mutual Fund) Regulations, 1996, a mutual fund is a trust-based investment vehicle that collects money from the public or a specific group of people by selling units of the fund. The money pooled is then invested in several assets such as securities, money market instruments, gold, silver, real estate, and other specified instruments.
In a recent consultation paper, SEBI proposed the introduction of a new product category called the New Asset Class (NAC). NAC aims to bridge the gap between portfolio management services (PMS) and mutual funds by offering increased flexibility in portfolio construction. The idea behind the proposal intends to serve majorly two-fold motives: firstly, the market is in dire need of a higher ticket-sized product with increased risk-taking capabilities of retail investors, and secondly, to eliminate the ‘unregulated’ investment products in similar or same arena.
2.UNVEILING THE NEW ASSET CLASS
(i) Bridging the Investment Gap
Mutual Funds and PMS have been somewhat of a constraint for investors with higher risk-taking propensity in the past. Mutual Funds with a minimum ticket size starting from ₹500 offer a high level of approachability but cannot afford risky manoeuvres like, for instance, speculative derivative positions or, say, inverse or bear Exchange Traded Funds (‘ETFs’). While PMSs, on the other hand, come at a cost of at least ₹50 lakhs, they also have similar restrictions regarding derivative usage, allowing it only for hedging. Hedging with derivatives allows investors to protect their portfolios from adverse price movements in the underlying assets. For instance, if an investor holds a large position in equities but expects the market to fall in the short term, they can use derivatives like futures or options to protect the value of their portfolio. By taking an offsetting position in a derivative contract, they can limit their losses if the market moves against them. This disparity has created a rather large gap between ₹500 for MFs and ₹50 lakhs for PMS, leaving middle-level investors with very few legal and genuine PMS to invest. The proposed NAC by SEBI aims towards filling this gap by providing a regulated investment platform that will be slightly more liberal with a minimum investment of ₹ 10 lakhs as compared to the PMS, although it has its risks. In the past, the regulator has started implementing some measures to halt these unregulated PMS, consequently issuing warnings and forbidding people from undertaking these activities.
(ii) A Step Towards Global Investment Strategies
It appears that SEBI’s proposed NAC framework is inspired by global investment approaches, especially the American 'Liquid Alternative Funds' model and Australian regulations governing Inverse ETFs. The Liquid Alternative Funds (LAF) framework provides retail investors a path to gain access to alternative fund strategies at a much lower initial investment compared to classic hedge funds. The smallest investment-permitted LAF can change dramatically, depending on the fund and its personnel. Still, given that they are established to serve retail investors better than traditional hedge funds, their minimum investments are, in general, much smaller and fall within the range of minimum investment requirements from USD 1,000 to USD 10,000. The NAC follows a similar route by delivering mid-tier Indian investors a sample of hedge fund strategies in a more supervised environment.In addition, SEBI's addition of Inverse ETFs in the NAC framework reflects similarities to Australian financial regulations on 'Bear ETFs' or inverse funds. Inverse ETFs are designed to produce the opposite return of an underlying index, often using derivatives such as futures contracts to achieve this goal. For instance, if an index drops by 1%, an Inverse ETF tracking that index will rise by approximately 1%. These funds allow investors to profit in declining markets, providing a unique tool for those seeking to protect their portfolios or take a speculative position during market downturns.
3.RISK LANDSCAPE OF SEBI'S NEW ASSET CLASS
Aimed at High-Net-Worth Individuals (HNI) individuals and institutional investors, the major increase in the minimum investment level seeks to draw in those capable of handling the greater risks associated with complex financial instruments. On one side, this would meet the needs of a “sophisticated” group of investors who understand the complexities of the Indian investment regime, but on the flip side, it might exclude retail investors, causing a fall in market liquidity and possibly increased systemic risks. The SEBI Act of 1992 is primarily investor protection oriented and this amendment almost appears to be more in keeping with a risk mitigation strategy, meaning only those with sufficient financial backing and investment know-how can participate.
That's a big change in risk tolerance, to propose to double the exposure limit for debt securities rated A and below, from 6% to 12% of NAV, and to increase limits for AAA and AA-rated securities. SEBI’s move to allow higher exposure to lower-rated debt securities could lead to enhanced yield opportunities but also raise the risk profile of the investment. The SEBI regulations typically limit such exposures to protect investors from concentrated credit risk; however, with the NAC, SEBI seems to be assuming that the investors will have the requisite sophistication to handle this increased risk. While the necessity for trustee and Asset Management Company (AMC) board approval brings a valuable governance framework, the overall NAV effect in case of defaults would be considerably more serious under these looser limits.
The continued expansion of derivative applications past hedging and portfolio rebalancing introduces considerable risk to the NAC. Although derivatives are strong instruments for increasing returns, they can also heighten losses, which means their management is critically important. At present, SEBI regulates derivatives mostly to hedging, which protects investors from speculative dangers. SEBI’s efforts to promote the expansion of their use are facilitating stronger investment practices, which might culminate in greater volatility and future disadvantages.
The simplification of investment regulations in the NAC is boosting a greater emphasis on Real Estate Investment Trusts (REIT) and Infrastructure Investment Trusts (InvIT), which in turn raises the stakes. Increasing single issue thresholds from 10% to 20% of NAV permits greater investment in assets that provide income, but it might also increase concentration risks, particularly in the volatile real estate and infrastructure areas. New amendments have presented new board nomination rights for unitholders that could help restore balance by bringing trust governance and investor interests more in line with each other. The augmented visibility might nonetheless pose serious threats, particularly in response to economic downturns.
4.ASSESSING THE IMPLICATIONS
The NAC framework, as proposed, marks an important evolution in the investment field by supplying a regulated pathway for mid-tier retail investors, thereby linking the gap between mutual funds and more speculative options including PMS and Alternative Investment Funds (AIF). This project represents a step forward in addressing the proliferation of unregistered and unauthorized entities that, even if they claim to provide high returns, put investors at serious financial risk. By introducing a new asset category that is both flexible and regulated, SEBI has made it easier for a larger group of investors to access more dynamic investment options with a minimum investment requirement of ₹ 10 lakhs.
The authorisation for derivative engagement beyond mere hedging activities subjects mid-tier investors to high-risk undertakings that are generally earmarked for seasoned investors. In contrast, both PMS and AIF, which are designed for investors with greater minimum investment requirements, impose restrictions on derivative utilisation. The large amount of derivative exposure that is permitted in the NAC structure causes some concern over whether such leveraged strategies are suitable for investors with small accounts. They should have taken a more conservative approach, gradually adding these high-risk instruments as they proved themselves in the PMS or AIF setting.
Not to mention the inclusion of Inverse or Bear Funds in the NAC which although may produce returns inversely related to an index only increases financial risk. Just from the inherent risks of inverse ETFs themselves, investors could lose a lot of money even if the index went back to its original level. However, a strong regulatory system with strict operational and disclosure requirements is a must to safeguard those investors who participate in such risky activities.
Furthermore, the tax issues about return from the NAC are not clear. Mutual funds receive a pass-through status, but Category III AIFs, which engage in more speculative investments, are taxed at the entity level. The Ministry of Finance must resolve the ambiguous tax structure that will pertain to the NAC. The NAC structure is a positive development for increasing investment freedom, but for there to be fair investor defenses and a dynamic middle investment sector, these problems must receive attention.
The concept of allowing exposure to derivatives for reasons apart from hedging and portfolio rebalancing adds a significant level of complication and risk. Although derivatives are effective instruments for increasing returns, they are also very effective in bringing about huge losses, especially when used speculatively. How one uses derivatives makes a huge difference between whether they will benefit or lose huge sums when applied to volatile and non-volatile assets. In volatile assets, options and futures would be vital hedging instruments for controlling risks relating to price instability. However, the price moves of the volatile assets make the potential for reinforced loss. At the same time, the derivatives of the non-volatile assets will have limited potential for extreme losses but also may return lower as a consequence of their price movement. Therefore, they are better suited to highly conservative strategies like income generation or minor portfolio adjustments. SEBI rules have typically restricted the application of derivatives to hedging to protect investors from too much risk exposure. Expanding their application under the NAC may draw in more assertive investors; however, it also magnifies the requirement for refined risk management processes.
5.CONCLUSION
The NAC framework proposed by SEBI functions as an innovative move, which reflects India’s readiness to take advantage of financial opportunities with the help of detailed and varied investment instruments like derivatives and Inverse ETFs. Reimagining mutual funds as the NAC forms a connection between classic mutual funds and PMS, giving a balanced treatment to risk and reward. Even though the framework is mostly admirable, it's important to thoroughly analyze the risk-return characteristics of particular approaches, such as long-short trading and Inverse ETFs, to confirm that investor protection does not suffer in the chase for elevated returns. The determinative factor for the success of the NAC will be the savvy and expertise of fund managers; their financial acumen will shape how skillfully they traverse these new, though potentially volatile, investment avenues.
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