New Investment Product Category: Is SEBI’s latest move commendable?

The Securities and Exchange Board of India (SEBI) has introduced a consultation paper proposing a new investment product category aimed at addressing a specific market need. This proposed asset class would offer investment options that sit between mutual funds (MFs) and PMS, filling a gap and providing greater flexibility in portfolio management. The new investment vehicle is designed for investors who are prepared to take on riskier market positions but find PMS schemes or AIFs out of reach. SEBI after reviewing the feedback and finalizing the regulations through stakeholder discussions, may issue the final regulations.

In the current bull market, new investors are eagerly looking for investment products that promise rapid returns. Meanwhile, seasoned investors who have successfully navigated various market cycles and earned from stocks or mutual funds are seeking opportunities that offer higher risks and potentially greater rewards. However, the regulated investment options available for such investors come with high entry barriers. For instance, Portfolio Management Schemes (PMS) require a minimum investment of Rs 50 lakh, and Alternative Investment Funds (AIFs) demand an entry amount of Rs 1 crore. Investors who have investible assets of Rs 50 lakh or more might be reluctant to commit their entire portfolio to a single investment manager due to the high ticket sizes involved.

Considering the scenario, the Securities and Exchange Board of India (SEBI) has introduced a consultation paper proposing a new investment product category aimed at addressing a specific market need. This proposed asset class would offer investment options that sit between mutual funds (MFs) and PMS, filling a gap and providing greater flexibility in portfolio management. The new investment vehicle is designed for investors who are prepared to take on riskier market positions but find PMS schemes or AIFs out of reach. SEBI after reviewing the feedback and finalizing the regulations through stakeholder discussions, may issue the final regulations.

New Wine in the New Bottle

The new product, consisting of many ‘strategies’, will be offered under a separate vertical by mutual fund houses. A new category of products is set to be introduced within the mutual fund framework, requiring a minimum investment of Rs 10 lakh. Investments can also be made through systematic investment plans (SIPs), provided the investor begins with a minimum lump sum of Rs 10 lakh.

This asset class will offer a risk-return profile that falls between that of mutual funds and PMS. It targets investors with a higher risk tolerance and larger investment amounts than typical mutual funds but with less risk than PMS. According to SEBI’s announcement, this new asset class aims to bridge the gap between mutual funds and PMS by providing a regulated option with greater flexibility, higher risk-taking potential, and a larger investment threshold to cater to the needs of a new generation of investors. The emergence of the new asset class is anticipated to introduce innovative investment products and strategies, potentially prompting some investors to shift away from existing high-risk options such as PMS and AIFs.

To ensure the effectiveness of the new asset class, which comes with relaxed prudential norms, it is crucial to address the associated enhanced risks. This can be managed by setting a higher minimum investment threshold. The proposed minimum investment amount for this new asset class is Rs 10 lakh per investor within an asset management company (AMC). Investors will need to invest at least Rs 10 lakh, either through a single or multiple investment strategies offered by the AMC or mutual fund. This requirement aims to deter retail investors and attract those with investable funds ranging from Rs 10 lakh to Rs 50 lakh, who might otherwise turn to unauthorized or unregistered portfolio management services. Like mutual fund schemes, the new asset class will offer investors options such as Systematic Investment Plans (SIPs), Systematic Withdrawal Plans (SWPs), and Systematic Transfer Plans (STPs).

SEBI Deserves Praise

Initially, only mutual funds with average AUM exceeding Rs 10,000 crore over the past three years, or those managed by seasoned Chief Investment Officers and fund managers, will be eligible to introduce this new asset class. SEBI has also suggested providing flexible investment and withdrawal options for this new asset. Redemption frequencies can include daily, weekly, fortnightly, monthly, quarterly, annual, or fixed maturities.

The fascinating aspect of this new asset class lies in its range of permissible instruments. According to the SEBI document, only SEBI-approved strategies can be utilized within this new asset class, including Long-Short Equity Funds and Inverse ETFs/Funds designed to deliver inverse index returns. Long-short equity funds involve taking both long and short positions in equity and related instruments. Inverse ETFs/Funds are designed to produce returns that move inversely to the underlying index. While individual traders have traditionally been able to engage in these strategies, SEBI has now permitted mutual funds to adopt them as well. This move likely aims to provide investors with a more professional alternative, as opposed to trading in derivatives on their own or following advice from financial influencers.

From a derivative trader’s perspective, a fundamental strategy involves executing a long-short trade, where the trader buys the strongest stock and shorts the weakest. Both positions are typically within the same sector. Long-short trades are considered one of the oldest strategies in the derivatives market. In a strong market, the number of long trades typically surpasses short trades, with futures positions forming a key part of the strategy. Conversely, in a weak market, short trades are more prevalent. However, the effectiveness of this strategy may be limited by SEBI regulation. According to SEBI guidelines, the total gross exposure, including derivatives, cannot exceed 100 per cent of net assets, and exposure through exchange-traded derivatives is capped at 50 per cent. This regulation restricts the leverage benefits usually associated with derivatives, potentially impacting the strategy’s overall returns.

The second strategy suggested by SEBI is particularly intriguing and likely to garner significant interest. Individual traders or investors often safeguard their portfolios by adopting hedge positions, such as purchasing put options, selling call options, or shorting futures on the indexes or stocks they own. However, this method is tax-inefficient, as derivative trades are subject to a 30 per cent tax rate. Inverse ETFs or Funds provide a tax-efficient method for hedging a portfolio, as long as finance ministers and tax authorities do not classify them as speculative and subject them to the same tax rates as derivatives. These ETFs or Funds are designed by using derivative instruments that gain value when the market falls. One key benefit of this new asset class is the added depth it will provide to the derivatives market, especially in stock futures involving long-short strategies.

Primary Drawback

The primary drawback of this instrument is that, because markets usually trend upward or stay within a range, with declines being brief and sharp, timing your entry and exit will be crucial. The fund is likely to show negative returns most of the time, but it is expected to experience significant gains during sudden market downturns.

Both instruments present a valuable opportunity for investors seeking higher-risk investments and protection for their portfolios during market downturns. Mutual funds will likely embrace this development, as they currently have the exclusive right to introduce these new instruments. However, managing these instruments demands a different strategy compared to traditional mutual funds. Fund managers who rely solely on fundamental analysis may find them challenging to manage effectively. Instead, those with a trader’s mindset are better equipped to handle these instruments. To conclude, the SEBI deserves commendation for its bold step in creating this new asset class. However, it would be beneficial if SEBI expanded the range of strategies to include relatively safer options, such as covered calls, and allowed professional fund managers in the PMS and AIF sectors to participate.

(With the input by Shivanand Pandit)