[By Siddhanth Singhi & Harsh Mishra]
The authors are students of Gujarat National Law University.
Introduction
SEBI has propelled India’s mutual fund landscape to evolve, by introducing a new asset class, Specialised Investment Funds or SIFs. This investment class is making headlines due to its multidirectional nature of investment such as equity, debt, debentures, REITs, InvITS etc. It was brought in with the aim of “bridging up the gap that existed between Portfolio Management Service (PMS) and Mutual Funds (MF)”, and allowing the investors to increase and diversify their investment, by not just restricting themselves to the equity market through Mutual funds. It primarily caters to High-Net-Worth Individuals (HNIs) and sophisticated investors, who are well aware and informed about the market dynamics.
The primary objective for the introduction of this asset class is to cater to those investors who lie between the void of PMS and MF because PMS is for the HNIs whereas the MF is more appropriate for retail investors due to its standardised structure. The PMS offers more diversification but requires high investment as it is high-risk contrary to Mutual Funds which are highly regulated and are suitable for retail investors who seek long-term returns.
So, to bridge the gap and facilitate the investors to gain access to various niche markets such as real estate, energy, infrastructure etc, this asset class was conceptualised by the SEBI. It is intended for those who have higher investment capabilities than the MFs but less than the PMS, and in order to provide sophisticated investors more flexibility in investing, it allows for great diversification, ensuring regulatory oversight.
The SEBI’s recent circular serves as a significant step towards addressing existing gaps in the framework. This piece aims to respectfully highlight these concerns and suggest constructive recommendations for enhancing the new asset class’s effectiveness.
Overlapping of Regulations
SIFs have a minimum investment requirement of Rs.10 lakhs, positioning it between Mutual Funds, PMS and Alternate Investment Funds (AIFs). AIFs function as a privately pooled investment vehicle which invests across an array of asset classes such as startups, venture funds, hedge funds etc. The significant point of contention between SIFs and AIFs lies in the fact that Category III AIF allows investment in hedge funds and derivatives, which is now being offered by SIF. Although the ticket size between both of them is vast, i.e. Rs. 10 lakhs for SIF and Rs. 1 crore for AIF, there exists a risk of overlapping between these investment vehicles as both allow investment in derivatives and hedge funds, which can lead to dilution of their identity.
This is because SIFs permit up to 25% investment (Regulation 5 and 6) in derivatives and unlike AIFs, it requires less corpus to invest, which allows Fund Managers to repackage the Category III AIF as the SIF, to capture the investors with less corpus. As a result, the fund managers will have the leeway to revamp the Category III AIF as SIF, as AIF requires a large investment and has no restriction on hedging, thereby increasing risk, contrary to SIF’s 25% limit. Hedging is a risk management strategy, similar to an insurance policy, used by investors to minimise their losses by investing in a position opposite to the existing investment. This allows the investors to offset any potential risk of losing in the existing investment. (Refer here for better understanding.)This restriction has the ability to attract investors as the fund managers will try to capture these large numbers of small investors, thereby broadening the reach of SIFs. However, this can create a problem of regulatory oversight as it can lead to confusion for investors and managers in the allocation of funds. Also, SIFs can “cannibalise” the AIF/PMS, by promoting sophisticated investment strategies into retail-like structure, which might confuse the investor. It is also pertinent to note that SIFs could divert the flows of AIFs towards themselves, as it has low investment requirements with high returns. However, this poses a challenge, that the AIFs were specifically brought in to cater for the needs of HNIs, due to their ability to invest in high-intensive investment sectors, such as start-ups, venture funds, Social Venture Funds etc. Also, investors are likely to then invest more in SIFs as it is more liquid in nature as compared to the AIFs, which have a longer lock-in period. Now, if the flow of funds starts diverting from AIFs to SIFs, it will impede the development of these AIF categories, as they will not get adequate funding. Therefore, it becomes necessary for SEBI to bring in certain rules for the differentiation of AIFs and SIFs, or else the SIFs may become “AIFs Lite”.
Regulatory Arbitrage
With the introduction of SIFs in the market, it can potentially take over the AIFs due to their low investment barrier and tax benefits. The SIFs are taxed like the Mutual Funds, meaning investors are only liable for taxes upon redemption or sale of their investments. Therefore, MFs are taxed in the hands of investors, and this same structure is devised for the SIFs. However, unlike SIFs, Category III AIFs are taxed at every transaction, sometimes rates varying as high as 30%, and need to pay long-term or short-term tax accordingly. Furthermore, AIFs are taxed at the fund level along with being taxed on dividends. This means that despite AIFs giving high returns, there will be substantial outflows from AIFs towards the SIFs, for the reason that it has low investment requirements and are taxed similarly to Mutual funds, thereby saving a lot of money for the investor. Any prudent or rational investor having Rs.1 crore will invest in ten different schemes of SIFs, each worth Rs.10 lakhs, rather than locking in one AIF.
This structure will particularly harm the Category III AIFs, as it invests in derivatives, hedge funds, and will redirect the investments coming towards it to the SIFs due to its liquid and flexible nature. This creates a regulatory arbitrage and may pave the way for SIFs to become a simplified version of the AIFs. It becomes essential to address this issue as AIFs are now seeing a surge in the number of investments being made every year, indicating that it is gaining immense traction in the market.
Catalyst for Climate Sustainability
SIFs have immense potential to bridge the gap between traditional investment options and sophisticated strategies due to their capacity for personalisation. It is pertinent to note that SIFs can be structured as funds prioritising Environmental, Social and Governance (ESG) Goals and classified thematically into sectors such as green energy & infrastructure, healthcare, climate-tech, sustainable agriculture etc. By creating such thematic SIFs, the investors will have an edge in the long term as these sectors hold the potential to yield high returns in future. Additionally, investing in these areas provides the necessary funding to implement ESG principles and promote a more sustainable Earth.
Investing in such SIFs also allows for portfolio diversification while contributing to vital social initiatives within the community. Furthermore, these funds may be made eligible for certain tax exemptions aimed at promoting investment in clean and renewable energy. Also, investment in these SIFs by the companies can be considered as part of their Corporate Social Responsibility (CSR) under Section 135 of the Companies Act, 2013. This will allow the infusion of more capital in these capital-intensive sectors, thereby enhancing their liquidity. As CSR is mandatory for prescribed companies, direct investment in SIFs will lead to an expansion in their number, ultimately resulting in greater benefits for the social sector due to its low investment barrier.
Way Forward
The recent introduction of Specialised Investment Funds (SIFs) by SEBI emphasises how it is concerned with the evolving needs of investors in India, as it has the potential to provide investors with secured financial returns due to its two-dimensional strategy. The SIFs were created to bridge the gap between the traditional investment strategy of Mutual Funds and the likes of sophisticated strategies such as PMS and AIFs. The ability of SIFs to invest in derivatives and equity simultaneously benefits and protects the investor even in conditions of bear market due to its diversified investments in various options such as REITs, InvITS, ETFs etc. Nevertheless, the concerns regarding the regulatory arbitrage need to be addressed by SEBI to ensure that the SIFs do not become a lite version of AIFs, where the HNIs find it more suitable to invest in SIFs due to its low investment barrier and high returns. Furthermore, the increasing number of sophisticated investors and expanding demographic of HNIs raises significant concerns regarding the performance of SIFs as they will surely drive its growth, thereby creating additional pressure on SIFs managers to generate higher returns.
As SIFs are a new asset class with no prior performance record, it raises concerns regarding their effective utilisation by the Indian AMCs, given their little experience with long-short funds. This is because SIFs offer intricate and diversified strategies across the derivatives and equity markets similar to what the hedge funds offer in countries like the USA, the U.K. etc. and Luxembourg’s SIF. However, SEBI has implemented a much stricter and regulated environment for the SIFs while simultaneously allowing for sufficient flexibility to foster SIFs’ growth within the Indian market. For example, the usage of risk bands, distinct branding guidelines, benchmark standards etc.
The onus is now on the Asset Management Companies (AMCs) and investors to optimize returns from the SIF’s diversified portfolio while ensuring compliance with regulatory standards. It becomes crucial for the stakeholders to navigate these dynamics effectively to sustain investor confidence and ensure the long-term viability of SIFs in the market.