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  • Gyanesh Mishra

SEBI’s New High-Risk Category of Mutual Funds: Highlights and Way Forward

[Gyanesh is a student at National Law University Odisha.]


Recently, the Securities and Exchange Board of India (SEBI) has proposed an introduction of a new mutual fund category that deals with high-risk but offers high rewards in terms of returns. In relation to the same, SEBI has sent a letter to the Association of Mutual Funds of India (AMFI) to assess the investor landscape and garner comments on this nascent category of mutual funds. The main aim behind brining in such a category is to regulate the high-risk investment market which is largely populated with investors that put their faith on unregistered advisors or high-risk portfolio management services (PMS) and ultimately lose out on their investments due to faulty advice. The contours and nitty-gritty of such a fund is still being deliberated upon by SEBI.


Understanding the Fund Management Categories


Currently, there are three broad avenues of fund management:


  1. Mutual funds: These are the most common type of retail funds which are widely available to common people. They do not have share classes and are freely traded in the open market. Moreover, these funds are professionally designed and come with a lot of options for the investor to choose from. All these features make it the most attractive fund to invest in along with having a minimal risk. However, as a consequence, the returns which are availed through mutual funds are at the lower end.

  2. PMS: PMS hold the second point in the scale of fund management in India. The most attractive feature of PMS is its flexibility and customization. Unlike mutual funds, PMS customize investor funds, create a collaborative strategy independently for each client, and focus on investing in areas best suited for the client. Due to their distinctive features and the associated high level of risk, PMS impose a substantial entry barrier in the form of the minimum investment size being set at INR 50,00,000. This high entry threshold renders it considerably less accessible to the common investor.

  3. Alternative investment funds (AIFs): AIFs cater to the business side of India. Such funds are heavily regulated by SEBI under the SEBI (Alternative Investment Funds) Regulations 2012 and can also be incorporated as an LLP. They offer 3 categories of funds which focus on new businesses, private companies, and publicly traded companies. Due to the huge investment amount, they have the strictest entry barrier where the minimum limit is INR 1,00,00,000, in addition to the requirement of complying with the other criteria.


SEBI aims at bringing a fourth category under the aforementioned avenues, a category which will fit somewhere between mutual funds and PMS and hence will have a comparatively higher risk than mutual funds and a lower entry barrier than the PMS. The main objective is to provide flexibility and regulation at the same time.


Regulating the High-Risk Market


The principal objective of the proposed mutual fund category lies in the regulation of the investor market that actively engages in high-risk investments and promises high rewards. In the pursuit of maximizing returns, unsophisticated investors often pay heed to unsolicited advice from unregistered investment advisors and gravitate towards high-risk PMS. Additionally, the emergence of "finfluencers" has witnessed a notable surge, wherein individuals claim expertise in investments and, in turn, mislead their audience into investing in high-risk financial instruments. More often than not, these finfluencers are backed by specific entities with the intention of promoting their shares and manipulating share prices.


In addressing these concerns, beyond merely exerting regulatory control over finfluencers, SEBI has persistently been cautioning the public against seeking advice from unregistered advisors. The introduction of a novel mutual fund category, characterized by its high-risk nature, serves as a strategic move by SEBI to divert investors' attention away from unregistered and unregulated advisors. By doing so, the intention is to encourage investors to opt for a more tightly regulated framework provided by mutual funds, thereby fostering a more secure and transparent investment environment.


Suggestive Framework for the New Fund Category


The details and specifications of the instruments which are going to form part of this fund are still in consultation. However, a few instruments which could be a good fit for such a scheme include:


  1. Momentum stocks: There are multiple momentum stocks which are divided into different caps (capitalization), such as large cap or small cap. The term “cap” generally indicates the value of stocks with regard to their market capitalization. Hence, the higher the cap, the higher the market capitalization. The scheme can include small cap, mini cap, and micro-cap instruments within its ambit. By including smaller caps, the scheme will ensure mass participation by the investors as the valuation of stocks under smaller caps remains lower than the larger ones.

  2. Derivatives: Derivatives are financial contracts whose value depends upon the underlying asset they are based on. Incorporating derivatives under the scheme will provide many benefits to the high-risk seeking investors, such as getting exposed to hedging risk, and diversification of investor’s portfolio and protection to their assets, but the same come with their own set of speculative risks.

  3. High-risk leveraging strategies: In order to achieve the goal of alluring high-risk investors into mutual funds, various leveraging strategies can be applied. For instance, margin trading can be put into place which will incentivize the investors to invest more, and options trading can be put into place which lets an investor control a large amount of an underlying asset with a marginal upfront payment.


The Apprehension of Reputational Damage


While the proposition of incentivising investors with a high-reward mutual fund scheme under the regulatory purview of SEBI appears innovative, it is not without its set of challenges. The primary concern that AMFI may confront is the potential for reputational damage. A high-reward scheme inherently carries a heightened level of risk. Consequently, if the scheme incurs substantial losses due to its high-risk leveraging strategies, the repercussions would extend beyond the scheme itself, impacting the entire INR 50 trillion Indian mutual fund industry. This scenario could erode investor confidence in AMFI as a regulatory authority, leading to a cascading effect of diminished investments in the wake of perceived investment failures.


Introducing a new scheme, in this context, might be construed more as an effort to unnecessarily complicate the regulatory landscape for investors rather than one designed to confer benefits upon them. A precedent for such repercussions was evident during the COVID-19 pandemic, when credit risk debt funds suffered setbacks due to induced liquidity issues, causing a significant dent in the overall reputation of mutual funds.


Conclusion


SEBI's initiative to introduce a fourth category of investment funds is commendable. In the intricate landscape of Indian investments, investors face notable challenges arising from misinformation and the prevalence of self-proclaimed investment gurus who exploit common investors. The scheme strategically aims for a middle ground, seeking equilibrium between the accessibility inherent in mutual funds and the regulated high-reward mechanism associated with PMS. The formulation and structuring of this novel scheme requires meticulous planning by SEBI, demanding a judicious and legally sound approach to facilitate its effective and widespread implementation. Given the considerable risk entailed in potential underperformance, a prudent formation and execution strategy becomes imperative for the successful realization of this scheme and, potentially, its legal and financial triumph.

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