[Adnan Danish and Zaier Ahmad are penultimate year BA LL.B. (Hons.) students at National Law Institute University, Bhopal ]
The Securities and Exchange Board of India (SEBI) has recently issued a consultation paper that aims to address a regulatory gap. Currently, SEBI-registered mutual funds can invest in various overseas securities, including American Depository Receipts (ADRs), Global Depository Receipts (GDRs), equity of overseas companies, and foreign government securities. However, investments in overseas mutual funds or unit trusts (MF/UTs) with exposure to Indian securities are not explicitly permitted under the SEBI Master Circular for Mutual Funds.
The proposed policy seeks to bridge this gap by allowing Indian mutual funds to invest in overseas MF/UTs that have exposure to Indian securities, subject to a strict cap. According to SEBI’s consultation paper, the exposure of these overseas funds to Indian securities should not exceed 20% of their net assets. Additionally, SEBI has outlined conditions to ensure compliance and transparency, including pooling of investments, independent management, and periodic disclosures.
The consultation paper is open for public comments until June 7, 2024. It invites feedback on various aspects, including the appropriateness of the exposure limit and criteria for investment in overseas MF/UTs.
The Consultation Paper
Indian mutual funds face restrictions from investing in overseas MFs/UTs that hold Indian securities, which has deterred many from making such investments. To address this issue and expand opportunities for Indian mutual funds, SEBI is proposing changes to the regulations. SEBI acknowledges that Indian securities present a compelling investment opportunity for foreign funds due to India’s robust economic growth. As a result of such growth, many international indices, exchange-traded funds (ETFs), mutual funds, and unit trusts include Indian securities in their portfolios. For instance, as of April 30, 2024, Indian securities constituted 18.08% of the MSCI Emerging Markets Index, and JP Morgan’s Emerging Markets Opportunities Fund allocated about 15% to Indian investments as of March 31, 2024.
In light of this, SEBI, following consultations with stakeholders and the Mutual Fund Advisory Committee (MFAC), has proposed permitting Indian mutual funds to invest in overseas MFs/UTs that invest a specific portion of their assets in Indian securities, provided that the total exposure to Indian securities by such overseas funds does not exceed 20% of their net assets. Additionally, Indian mutual fund schemes must ensure that all investors’ contributions to an overseas MF/UT are combined into a single investment vehicle without any side vehicles. The corpus of an overseas MF/UT must be a blind pool, meaning it should have a common portfolio with no segregated portfolios, ensuring all investors have equal and proportionate rights in the fund. SEBI also recommended prohibiting advisory agreements between Indian mutual funds and the underlying overseas MFs to prevent conflicts of interest.
The paper provides that where the exposure to Indian securities by overseas MFs/UTs exceeds 20% at the time of either initial or subsequent investments, SEBI will consider it a non-compliance issue. However, if the exposure surpasses the 20% limit after the investment, an observance period of six months will be allowed for the Indian mutual fund schemes to monitor the portfolio rebalancing activities of the overseas MF/UT. During this period, the Indian mutual fund scheme must not make new investments in the overseas MF/UT. Investments can resume once the exposure to Indian securities by the overseas MF/UT falls back below the 20% threshold.
Analysis
The consultation paper underscores that the total exposure to Indian securities by overseas funds should be capped at 20% of their net assets. Pushing this ceiling limit higher would dilute the label of Indian fund of funds (FoFs). Direct investment in Indian securities and mutual funds is generally more cost-effective for Indian investors compared to investing through an overseas FoF for several reasons, the first being that direct investments in domestic mutual funds come with lower management fees and expense ratios. Additionally, some FoFs also carry performance fees, and the cumulative effect of these fees can significantly reduce net returns for investors. Raising the exposure to Indian securities and exceeding the 20% threshold could impose additional forex and conversion costs on domestic investors, which they could easily avoid by choosing domestic mutual funds.
Furthermore, when mutual fund units are redeemed, they are treated as capital gains under section 45 of the Income Tax Act, 1961. The tax rate on these capital gains varies depending on the type of mutual fund scheme and the holding period. For equity-oriented schemes, capital gains are considered short-term if the investment is held for less than 12 months. For debt funds, the holding period for short-term capital gains is 36 months. Gains from international mutual funds fall under section 50AA of the Income Tax Act, 1961, classified as specified mutual funds, and are taxed similarly to debt mutual funds at the individual’s income tax slab rate. Previously, long-term capital gains from international funds were taxed at 20% with indexation benefits. In contrast, for domestic mutual funds with over 65% equity allocation, short-term capital gains on these investments are taxed at 15% without indexation, and long-term capital gains are taxed at 10%, with no tax on capital gains up to Rs. 1 lakh. Therefore, clearly, from a tax perspective, it is more advantageous to invest in domestic mutual funds than in FoFs with more than 20% exposure to Indian securities.
Additionally, it is recommended that passive schemes such as overseas ETFs and index funds be excluded from the 20% exposure limit. ETFs and index funds track indices that periodically rebalance based on market capitalization or other predefined rules. This automatic and systematic rebalancing reduces the need for discretionary decision-making by fund managers. The core concept of an index fund is to replicate the performance of an index passively. Imposing exposure limits on ETFs would undermine this concept by treating them like actively managed funds, which they are not. Investors choose ETFs for their passive management, low costs, and transparency. Including ETFs under exposure criteria would alter their risk-return profile and could lead to unintended consequences, such as reduced accessibility and increased costs.
Although the consultation paper facilitates investment by Indian mutual funds in overseas mutual funds investing a portion of their assets in Indian securities, this scheme cannot succeed without easing the Reserve Bank of India’s investment limits in foreign assets. On June 3, 2021, SEBI issued a circular allowing mutual funds to make overseas investments subject to a maximum of US $1 billion per mutual fund, within an overall industry limit of US $7 billion. For overseas ETFs, the limit is set at US $300 million per mutual fund, within an overall industry limit of US $1 billion. With the increased inflow of investments by Indians into global funds, these limits have nearly been reached. Consequently, SEBI has issued notices to halt new deposits or lump-sum deposits in certain FoF schemes. Some asset management companies (AMCs) have informed their investors that they will no longer accept fresh lump-sum deposits. Given this situation, SEBI should consider increasing the industry-wide investment limit. When these overseas mutual funds allocate a substantial portion of their assets to Indian securities, they will surely benefit from the strong performance and returns of Indian companies, which can further attract Indian investors and fund managers of Indian AMCs to invest and create new Fund of Funds Schemes. Increasing the investment limit will provide investors with greater opportunities to diversify their portfolios internationally while still gaining exposure to the robust performance of Indian securities.
Conclusion
SEBI’s proposed framework to allow Indian mutual funds to invest in overseas MF/UTs with limited exposure to Indian securities is a step towards bridging regulatory gaps and expanding investment avenues. However, the cap on exposure and the conditions laid out are critical to maintaining cost-effectiveness and compliance. The exclusion of passive schemes like ETFs from the exposure limit is a necessary move to preserve their passive investment nature. Nevertheless, the current investment limits set by the SEBI may hinder the full potential of this policy. By increasing these limits, SEBI can enhance diversification opportunities for investors and better leverage the strong performance of Indian securities, thus creating a more robust and inclusive investment landscape.
– Adnan Danish & Zaier Ahmad
As a corporate lawyer at an asset management company, I find SEBI’s new proposal on overseas investments by Indian mutual funds to be a welcome change. Allowing our mutual funds to invest in overseas funds with up to 20% exposure to Indian securities could open up more diverse opportunities for our investors.However, the current investment limits—US $1 billion per mutual fund and an industry cap of US $7 billion—feel restrictive given the increasing interest in global markets. Raising these caps would better meet the growing demand for international diversification.I also appreciate SEBI’s decision to exclude passive schemes like ETFs from the 20% exposure limit, as it maintains their low-cost, transparent nature. Overall, while SEBI’s proposal is a positive step forward, increasing the investment limits is crucial for maximizing its potential benefits.