SEBI’s proposal on new risky asset class for mutual funds: Blessing or a curse?

SEBI is looking for comments or suggestions on the proposal New Asset Class or product category till August 6.

The capital markets regulator’s proposals on launching a new asset class between mutual funds and portfolio management services (PMS) will open Indian investors to different investment products, styles and approaches. However, experts feel that certain suggestions may exposure investors to some of the riskiest instruments.

The Securities and Exchange Board of India (SEBI) on July 16 proposed a new asset class that provides investors with a regulated investment product featuring higher risk-taking capabilities and a higher ticket size, aimed at curbing the proliferation of unregistered and unauthorised investment products.

Key proposals

The current range of investment products with varying risk-reward profiles range from those from mutual fund houses with entry points as low as Rs 10 to PMS products with a ticket size of Rs 50 lakh and alternative investment funds (AIFs) with a minimum investment value of Rs 1 crore.

The minimum investment amount under the new asset class that , which would be offered by mutual funds, is proposed to be Rs 10 lakh.

To make sure there is a minimum expertise threshold in running such products, SEBI has proposed that an asset management company (AMC) proposing to float the new product should have been in operation for a minimum of three years and have had average assets under management (AUM) of at least Rs 10,000 crore in the in three immediately preceding years.

Alternatively, to launch such products, the AMC needs to appoint a chief investment officer (CIO) who has experience of fund management of at least 10 years and has handled AUM of at least Rs 5,000 crore. In addition, the fund manager for this new asset class should have experience of fund management of at least seven years and handling AUM of not less than Rs 3,000 crore.

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As examples of the new asset class or “Investment Strategies”, SEBI has proposed that products “Long-short Equity Fund” and “Inverse Exchange-Traded Fund” could be offered to investors.

Additionally, the new asset class is proposed to be able to take exposure in derivatives for purposes other than hedging and portfolio rebalancing. This is expected to provide more flexibility and risk-taking in investments and potentially generate higher returns.

“The rising number of mutual fund folios, subscribers to PMSes and AIFs as well as F&O (future and options) traders suggest that Indian investors are ready for capital markets either directly or through products. There is a lot of readiness for higher ticket sizes and a clear appetite for risk. There was a lack of a product which is more aggressive than mutual funds,” said Nirav Karkera, head, research, Fisdom, an investment research firm.

Nikunj Saraf, vice president, Choice Wealth, believes that the proposals will enhance investment flexibility and potentially yield higher returns.

Will this help investors?

According to the mutual fund industry, the new asset class, which creates a structure for differentiated and higher risk strategies, looks promising for investors.

Radhika Gupta, managing director and chief executive officer, Edelweiss Mutual Fund, is happy that this new asset class is available through the mutual fund route. “AMC businesses of the future will build multiple centres of expertise on a platform rather than a single style or individual-driven business. From a customer point of view, there is nothing like the convenience of the good old MF platform—regulated, transparent, with great features like SIPs (systematic investment plans) and now getting increasingly open for innovation,” she tweeted.

According to SEBI, the absence of investment product between PMSes and mutual funds has inadvertently nudged many investors, especially younger ones, towards unregistered and unauthorised investment schemes or entities.

Sandeep Jethwani, co-founder of wealth management firm Dezerv, said that investors with higher risk profiles can now access regulated opportunities without the high minimum thresholds of PMS and AIF or resorting to unregulated structures, which bodes really well for protection of wealth that India creates.

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“Further, the new product class can help investors gain access to a newer set of strategies such as long-short equities, inverse ETFs (exchange-traded funds), etc, which can help them express specific views on the market,” said Kaustubh Belapurkar, director, fund research, at Morningstar Investment Research India.

Also, by taking the AMC route, stringent regulations similar to those for mutual funds will ensure transparency.

“SEBI has outlined specific rules for these funds, reassuring investors that this new category will be closely monitored, thereby minimising potential risks,” said Feroze Azeez, deputy CEO, Anand Rathi Wealth.

Riskiest products

One product SEBI has illustrated that can be launched under the new asset class is inverse ETF. Also called ‘short ETF’ or ‘bear ETF’, this instrument seeks to generate returns that are negatively correlated to the returns of the underlying index.

Not all are convinced by this proposition; some even call it a terrible idea. “Example: If market goes up 10 percent, from 100 to 110, and then falls 9.09 percent, you get back to 100 or par. Inverse ETF would work as follows: When the market goes up 10 percent, ETF falls 10 percent, so the NAV (net asset value) becomes 90. Then when market falls 9.09 percent, the NAV goes up 9.09 percent and the final NAV is 98.18 So Index is flat but NAV is down to 98.18,” Samir Arora, founder and fund manager of PMS firm Helios Capital Management tweeted.

“You do with any combination of returns (plus and minus) and you will have a miserable experience unless u (you) get absolute one-way slide in the market or u hold only for one day. This is arithmetic and well realized by many—but still companies continue to launch such funds,” Arora added.

Echoing similar views, Kunal Valia, founder, StatLane, a SEBI-registered research analyst, said that some investors might be getting “gung-ho about inverse ETFs, but in reality they are the highest risk products".

“For example, if someone invests in an inverse Nifty ETF for the long term and the index rises 100 percent, the AUM of that strategy can even become zero. Inverse ETF is something that needs more discussion and it's not a product which should be offered in the Rs 10 lakh to 50 lakh portfolio space. First, it should be allowed at the AIF level, then PMS level and then maybe in the new asset class category,” Valia said.

Not everyone’s cup of tea

The proposal to allow the new asset class to take exposure in derivatives for purposes other than hedging and portfolio rebalancing has also raised concerns.

At present, even PMSes with Rs 50 lakh minimum ticket size are not allowed to take exposure to derivatives apart from hedging purposes. “Now, a Rs 10-lakh product can be allowed to invest in derivatives under the new proposals. I am not sure what problem we trying to solve here. I am not convinced that the minimum ticket size of Rs 10 lakh should also be allowed to do take bets like this,” said Kirtan Shah, founder of Credence Wealth Advisors.

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Shah also has reservations on offering long-short equity funds to Rs 10-lakh portfolio investors.

As per SEBI, this fund category seeks to deliver returns by taking long and short positions in equity and equity-related instruments. For example, the fund may be bullish on the automobile sector and bearish on the IT sector, and may invest in both these sectors by going long on the auto sector and short on IT.

“The problem is when you are invested in a PMS or a mutual fund, which are long-only funds, at some point in time you are going to be right when the market goes up and you will make returns. But in a product where you allow 50 percent derivatives, you can theoretically be perpetually wrong. You may be short, but the market goes up, or you may be long and the market goes down. Do we really need such solutions for retail investors?” said Shah.

Clarity needed

One of the key advantages of investing in mutual fund schemes is favourable taxation, meaning selling and buying of equities by mutual funds do not attract tax, which is not in the case of PMSes.

Dezerv’s Jethwani believes that the decision on taxation—whether at the mutual fund level or under new norms—will be crucial for its adoption. “It remains to be seen if there will be changes in the tax code to boost assets here,” he said.

Further, experts are also looking for clarity on whether SEBI-registered investment advisors (RIAs) or research analysts (RAs) would be allowed to recommend the new asset class to clients.

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“Involving RIAs and RAs and encouraging them to launch such strategies under their banners will be beneficial to this category,” said Valia.

SEBI will take comments or suggestions on the proposal product category till August 6.