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Priyanshu Ranjan, Kritika Jeswani

SEBI's New Asset Class: Bid to Create a New Investor Class

[Priyanshu and Kritika are students at Gujarat National Law University.]


On 16 July 2024, the Securities and Exchange Board of India (SEBI) published a consultation paper seeking public and expert opinion regarding the proposals included in the paper. Through the paper, the regulator seeks to introduce a new asset class, which will have a ticket size of INR 10,00,000, falling right between mutual funds and portfolio management services (PMSs). With this unique characteristic, SEBI seeks to offer a more suited asset category to investors who have a greater appetite for risk than what is typical of mutual fund investments but aren’t willing to invest in PMS.


Through this article, the authors intend to deep dive and investigate the viability of such proposals, especially the proposal concerning its exposure in the derivative markets apart from the already allowed practices of hedging and portfolio rebalancing.


Two-way Eligibility


Requiring a minimum of 3 years of operation ensures that only those Mutual Funds with a proven track record can offer the new asset class. As pointed out by the CEO of Edelweiss, Radhika Gupta and other experts, allowing already existing AMCs to participate in this new asset would help mitigate the risk associated with inexperienced firms. The threshold of INR 10,000 crores demonstrates the fund’s ability to manage substantial assets, indicating financial stability and operational expertise. Moreover, ensuring no actions under specific sections of the SEBI Act 1992 promotes a history of regulatory compliance, which is crucial for maintaining investor trust.


Appointing a CIO and an additional fund manager with significant experience and AUM management ensures that even newer or smaller funds have competent leadership to manage the new asset class effectively. This route provides flexibility for new entrants and smaller AMCs to participate, promoting diversity and innovation in the market while maintaining a high standard of fund management.


Structuring the New Asset Class


An appropriate structure


Investment managers can better manage liquidity by allowing adjusted redemption frequencies based on the type of investments without placing unnecessary restrictions on investors. The amount of liquidity that each investor requires varies. Giving redemption options flexibility increases investor satisfaction and appeals to a wider range of investors. The redemption frequencies' flexibility is in line with recommended procedures for managing liquidity risk. Research indicates that providing a choice of redemption frequency can draw in a varied group of investors with varying levels of liquidity.


Increased liquidity and marketability


Listing investment strategy units on reputable stock exchanges increases investor liquidity and improves market accessibility, particularly for strategies with extended redemption periods. The advantages of increased liquidity and market efficiency have been proven by exchange-traded funds (ETFs) and other listed financial products.


Keeping a necessary oversight


Strong regulatory oversight is crucial for maintaining investor trust and protecting against malpractices. Therefore, requiring SEBI’s approval to launch new investment strategies ensures that these products meet regulatory standards and are in the best interest of investors.


Compounded Losses from Inverse ETFs


Investing in inverse ETFs could prove not to be as rewarding as the risks assumed by the investors for taking up such investment strategies. An inverse ETF moves in the opposite direction of an underlying security (e.g. an index fund). When the index fund is 10% high in a single day, the inverse ETF would fall down by 10%. Although the profits or loss from the Inverse ETF mirrors the movement of the underlying security for a single day, the effect of compounding makes them unappealing. As highlighted in this example, a security which rose by 1% on the first day and fell by 3% and 5% on the second and third days, respectively, will have fallen by 9.3% due to the compounding effects. However, owing to the same compounding effect, at the same time, the inverse ETFs attached to them would only have risen by 7.1% in the three-day span.


Therefore, investment in a reverse ETF would require meticulous short-term everyday investment decisions, making them labor-intensive and high-cost endeavours.


New Asset Class and Derivatives


Beyond asset rebalancing and hedging


SEBI is considering the prospect of exposing this new asset class to the derivative markets as it can generate greater rewards than mutual funds, which are only exposed to derivatives for the purpose of hedging and asset rebalancing, for investors who have a greater appetite for risk. However, while determining the possible ways to leverage the derivative market for the investors, it becomes equally important to identify the limits of such exposure beyond which the investor is not ready to bear risks. One such out-of-bound use case of derivatives is leveraging. 


No to leveraging


Leveraging refers to the investment strategy through which an investor can use his limited funds to purchase securities which are valued more than the funds he has actually invested. It is done for the purpose of earning greater returns from a seemingly smaller amount of funds. For example, an investor, F, may use the USD 5,000 available with him to invest in securities valued more than USD 10,000 with the prospect of earning twice what he would have earned had he not only purchased securities to the tune of USD 5,000. However, leveraging is truly a double-edged sword, as the prospect of multiplying returns also comes with the risk of multiplied losses. 


SEBI prohibits AMCs and PMSs from engaging in leveraging activities because of the risks involved, and considering that the new asset falls between these two categories, it should follow the same. Through Para 10.2 of the proposal, SEBI clearly restricts a cumulative asset exposure of the fund from being higher than 100% of the net assets. The additional USD 5,000 exists in the form of a loan.


A consent-based approach


SEBI permits PMSs to invest in the derivative market in various ways upon seeking the consent of the investor for such activity. Instead of allowing the new asset class to be exposed to the derivative market for specific purposes, SEBI should consider adopting a similar approach as PMSs. Such a step would encourage the practice of taking informed risks among the new class of investors.  Depending on the consent of the investors, the new asset class could benefit from investment activities like speculation and arbitrage. 


Minimum Standard of Risk Aversion


Para 10.2 prohibits the value of the cumulative gross exposure of the investment (including derivatives as well as other instruments) from exceeding 100% of the net asset value of the investment strategy. So, the exposure of the investment strategy to various securities should never be more than the net asset value of that investment strategy. This is to ensure that the funds are not leveraged to increase the asset exposure of the investment strategy in anticipation of greater returns. Such a restriction has been imposed while keeping in mind the catastrophic effects of leveraging, as discussed above.


Para 10.2.1(a) limits exposure to derivatives of a single stock to 10% of the net assets of an investment strategy, further curtailing the risks associated with investments in the derivative market. Moreover, the illustration table clarifies that the investment limit of 15% in the stock of a single company (as provided in para 9.5) is inclusive of the investment in derivatives of the stock of a single company [as per Para 10.2.1(a)]. 


Therefore, through para 10, SEBI has sought to ensure a minimum standard of risk aversion that the AMCs need to adhere to while considering taking exposure to the derivative market for purposes other than hedging and risk management, as such uses of derivatives are bound to have a greater risk.


Exception Based on Types of Funds and Purpose of Derivative Exposure


Para 10.2.1 sets out the limit for the investments allowed in the derivative market at 50% of the net assets of the Investment strategy. However, such a limit could be extended, considering that the investment limit in such products in the case of mutual funds (which are associated with lesser risk profiles) is the same. 


SEBI, through para 10.2.1. (b), also implies that such a limit can be extendable in cases of investment in Index funds/ETFs (less volatile and risky). Moreover, it is established that the use of derivatives for the purpose of hedging and risk management falls under the lower-risk category. Therefore, the exception to exceed the 50% limit shall not be limited to investment in derivatives of Index funds/ETFs but should also be extended to investments where the derivatives are used purely for the purpose of hedging and risk management. 


Exception Miscellaneous Proposals


Branding of the new asset class


When making investment decisions, investors frequently depend on brand awareness, according to behavioural finance. Because brand association can lead to poor decisions, clear branding can help avoid this. Research has indicated that unambiguous and conspicuous disclaimers considerably augment investor cognizance and comprehension of financial instruments. To safeguard investors and uphold market integrity, for instance, the Securities and Exchange Commission of the United States requires explicit labelling and disclosure standards for complicated and high-risk investment products.


In line with the principles of efficient markets, wherein knowledgeable investors may make decisions that precisely represent the underlying risks and rewards of their investments, clear branding and communication lower the information cost. Therefore, branding and labelling aid in preventing negative externalities whereby risky product failure or bad performance could damage the reputation of conventional mutual funds. This makes sure that investors' faith in well-known products isn't negatively impacted. 


Disclosures


The distinct risk band for the new asset class avoids confusion with traditional mutual fund schemes, clearly communicating the different risk profiles. Investors receive timely and accurate information about the holdings and modifications to their investment plans through monthly portfolio disclosures. Since AMCs' decisions are often scrutinized, they would have an incentive to uphold high standards of portfolio management and act in investors' best interests. On the other hand, gathering, confirming, and disseminating reliable portfolio data calls for a substantial amount of time and money each month. 


Transparency in constitutional documents is a best practice in financial regulation, promoting informed investment decisions and enhancing market integrity. Therefore, making constitutional documents publicly available ensures that investors have access to comprehensive information about the investment strategies, governance, and operational aspects of the new asset class.


Conclusion


The new asset class tries to identify a new segment of investors, making the securities market more accommodative. However, a lot of its proposals, like the proposal to include inverse ETFs and not clearly define the purposes for which the asset could be exposed to the derivatives market, make it vulnerable to the various issues inherent to them. Therefore, the effectiveness of this new asset class will depend on careful implementation and oversight. Striking the right balance between innovation, risk management, and investor protection will be key to its success. By encouraging feedback and refining these proposals, SEBI can create a robust framework that supports a healthy, dynamic market while safeguarding investor interests.


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