[Parv Pancholi is a final year B.B.A. LL.B. (Hons.) student at National Law University Odisha, Cuttack]
The Indian investment market continues to be an attractive hotspot for the domestic and foreign investors, offering a diverse range of financial products like mutual funds (“MFs”), alternative investment funds (“AIFs”), and portfolio management services (“PMSs”.) In recent years, a growing inclination among savers to diversify beyond bank deposits has spurred a demand for bespoke investment options with varying levels of risks and returns. Perhaps, as a response to a widened appetite for financial products, the Securities Exchange Board of India (“SEBI”) rolled out a Consultation Paper proposing a framework for a new asset class (“NAC”) designed specifically for the upper middle-class investors seeking to capitalise on strategically riskier opportunities.
This post is an attempt to critically explore the features of the NAC and offer an insight into its financial soundness in light of the expanding Indian investment funds industry.
Backdrop of the Proposed NAC
The investors with an appetite for riskier financial styles and approaches have historically found MFs and PMSs to be restrictive. While the regulatory ecosystem allows an investor to participate in MFs with a ticket size of as low as ₹500, it precludes MFs from engaging in riskier financial approaches and investments—such as speculative exposures to derivatives and investing in Inverse or Bear ETFs. Similarly, the PMS framework requires a minimum investment of at least ₹50 lakhs, but does not permit the PMSs to engage in derivative exposures other than for hedging.
This wide ticket range of ₹500 for MFs and ₹50 lakhs for PMS has created a significant gap for the investors in the mid financial capacity, nudging them into unregulated and unregistered PMSs. In the past, the regulatory watchdog has taken considerable steps to curb the proliferation of these unregulated PMSs by cautioning these entities and banning individuals from entering into these unregistered and unauthorised PMSs. The proposed NAC is an attempt from SEBI to fill this gap between MF and PMS and offer a regulated, flexible and structured option of investment to the mid-tier investors with a lower minimum ticket size of ₹10 lakhs.
Key Differentiators of NAC
The proposed NAC is envisioned as a regulated structure under the MF structure, encompassing a balanced risk-based framework and a more liberalised prudential norm compared to the MFs, while maintaining a higher ‘minimum contribution’ of ₹10 lakhs from each investor.
To ensure an adequate experience, the Consultation Paper has proposed that an NAC can be launched by an existing MF or an asset management company (“AMC”) with a minimum experience of three years and an average asset under management (“AUM”) of minimum ₹10,000 crores over the preceding three years. Alternatively, SEBI also permits an AMC to launch an NAC if it has a chief investment officer (“CIO”) managing an AUM of ₹5,000 crores for ten years, along with a fund manager with seven years of experience in managing AUM of ₹3,000 crores.
Notably, the NAC has been afforded the flexibility to engage in to riskier and diverse business opportunities, including strategic investment approaches like long-short equity funds and Inverse ETFs. The long-short approach permitted to the NAC marks a significant departure from the traditional long-only approach allowed for the classical MFs. Peculiarly, the proposed class has been permitted to engage in derivatives even for non-hedging and non-portfolio rebalancing purposes, an asset class not permitted even in the sophisticated investor-based PMS framework.
However, in order to ensure adequate investor protection, the proposed NAC framework also introduces certain stringent conditions for investment. To wit, the proposed NAC is permitted to invest only 15% of its net asset value (“NAV”) in the equity and equity related instruments of an entity. Moreover, the sectoral cap for permissible investments in debt securities has been increased to 25% for NAC from the 20% cap provided for the NAC debt-oriented MF schemes. This increment reflects an attempt to create a balanced investment landscape for NAC that accommodates a high-risk nature of equity investment and the relative safety offered by the debt investment.
Global Practices
The proposed NAC framework appears to have been borrowed from the American version of ‘Hedge Fund Lite’ framework or ‘Liquid Alternative Framework’, which was introduced under the Investment Company Act, 1940. This framework aims to allow hedge fund-type strategies to investors at a lower entry point than the traditional hedge funds. More specifically, these funds generally have variable ticket sizes with typical investments ranging between $5,000 to $2,50,000, compared to the minimum $1 million requirement for a traditional hedge fund. Similar to the NAC framework, the Hedge Fund Lite framework also provides operational regulations designed to safeguard investors’ interests. Stringent transparency and liquidity norms vis-à-vis classical hedge funds are the crucial highlights of the Hedge Fund Lite framework.
Additionally, SEBI seems to have drawn inspiration from the Australian financial regulation with regard to the ‘Bear ETFs’ or ‘Inverse ETFs.’ These funds tend to gain when there is an adverse market condition or a decline in the value of the underlying asset or benchmark value. The Australian Securities and Investments Commission (“ASIC”) regulates these funds under the Corporation Act of 2001, categorising them into single and leveraged inverse funds. These Bear Funds are permitted to engage into diversified financial instruments, including derivatives, to hedge or speculate on the probable market changes.
Viability Analysis of the NAC
The proposed NAC framework is a welcome move that offers a regulated investment opportunity to a large group of mid-tier retail investors. These investors were largely in a fix on account of the huge gap between the low risk-taking MFs and the riskier PMS or AIF structures. This proposed asset class is a step to weed out the proliferation of unregistered and unauthorised entities that marketed themselves as incredibly high interest gainers, while exposing the investors to financial vulnerabilities.
The lighter-touch provided in the proposed framework is a positive step, which fosters flexibility of investment opportunities to the managers with expertise in the strategic high-risk taking strategies, such as naked derivative exposure or market prediction for Bear Funds. The age-old adage of ‘high risk–high return’ translates into SEBI’s acknowledgment of the fact that Indian investors are readying themselves for an intensified risk appetite approach and bracing themselves for more exotic instruments like derivatives for riskier objectives. The flexibility offered in prudential norms along with the stringency in the transparency norms is a promising attempt to strike a balance between the ease of earning and the investor protection.
While the NAC framework is laudable for its liberalised investment framework, it does raise certain concerns that merit to be flagged herein.
Firstly, the green signal provided to derivative engagement even for non-hedging purposes severely exposes the mid-tier investors to a significant risky venture. To put it in perspective, PMS framework—which was devised for the sophisticated investors—also prohibits the usage of derivatives for purposes other than hedging. Similarly, the AIFs, devised for the investors with minimum ticket size of ₹1 crore, are also allowed to use derivates only up to twice the value of their portfolios. While SEBI’s positive approach for risky ventures is acknowledged, an outright permission to a highly volatile use of derivatives for investors with ticket size of ₹10 lakh merits a reconsideration. Au contraire, a phased approach, beginning with PMS and slowly shifting to the proposed NAC framework based on their results, would have been more prudent.
Secondly, the proposed introduction of Inverse Funds or Bear Funds yet again presents potential financial risks to the investors. Often connoted as one of the riskiest investment styles, the Inverse Funds try to generate returns inversely co-related to the performance of an underlying index. The risk in this strategy can be understood by referring to an illustration: if an index soars by 25% from 40 to 50 and then then descends back by 20% to its original position, an Inverse ETF (with an initial NAV of 40) would inversely decline by 25% to 30 in the first instance, and rise by 20% to 36 in the second. This illustration is a demonstration of the risk associated with Inverse ETFs, wherein despite the index returning to its position, the net change led to a decline in the NAV of the ETF. A controlled risk-environment with detailed operational and disclosure requirements in addition to the MF regulations would be apposite to provide investment safeguards to upper-middle class investors in such risky ventures.
Lastly, the proposed NAC framework lacks clarity on the taxability of the generated returns, which is usually an important consideration in choosing any investment opportunity. While the MFs are provided pass-through status for such taxability, a Category III AIF which is permitted to indulge in riskier bets is taxed at the entity level only. The question, therefore, looms large whether the proposed framework would follow MF route or would align with the AIFs tax treatment. This lack of clarity about the taxability of the proposed NAC framework merits a due clarification from the Ministry of Finance.
Concluding Remarks
The proposed NAC framework is a progressive step by SEBI that reflects the preparedness of our country to grab financial opportunities even by employing complex and diverse investment tools, like derivatives and Inverse ETFs. The remodelling of MFs into the NAC serves to be a midway between MFs and the PMS. While the proposed framework is generally praiseworthy, the risk-return benefits for certain investment styles like long-short trading and Inverse ETFs require a careful consideration to meet the desired objective without discounting investor protection. Finally, the ultimate success of the NAC would depend upon the prudence and financial wisdom of fund managers in navigating these novel investment avenues.
– Parv Pancholi