SEBI's proposal for Indian mutual funds' exposure

See if this makes sense - you invest in a US fund via an Indian mutual fund, which is supposed to capture the US equity market. However, that fund invests a large part of your money in India. You could have directly done that - invest in direct stocks in India!

The market regulators in India feel the same. Hence, recently it came up with a proposal for Indian mutual funds' exposure to overseas funds, which invest in Indian securities. In this article, we look at the details.

SEBI's proposal

Last month, the Securities and Exchange Board of India (SEBI) issued a consultation paper. The SEBI found a regulatory gap, and it wants to fix it. As per the existing mandates, the Indian mutual fund can invest in various overseas securities like Global Depository Receipts (GDRs), American Depository Receipts (ADRs), foreign government securities, and overseas companies' equity. However, as per SEBI's master circular, the investment in overseas mutual funds with exposure to Indian securities is not explicitly mentioned.

Now, the new proposal is to allow Indian mutual funds to invest in overseas mutual funds that have exposure to Indian securities. The new proposal will bridge the existing gap. However, there will be a strict cap.

As per the consultation paper, the exposure of these overseas funds to Indian securities should not exceed more than 20% of their assets. For example, if an overseas fund A has a total AUM of Rs 10,000, its maximum exposure in Indian securities should not exceed Rs 2,000 crore.

Why SEBI is thinking about it now? The reason is simple - many international funds are investing in India to take advantage of the Indian growth story. For example, as of March 31, 2024, Indian securities constituted 18.08% of the MSCI Emerging Markets Index, and JP Morgan’s Emerging Markets Opportunities Fund had a 15% allocation to Indian investments.

On top of this, SEBI has given conditions to ensure compliance and transparency, including pooling of investments, independent management, and periodic disclosures.

The reason behind the proposal

The reason behind the proposal is simple. When you invest in these international funds, your aim is diversification. In most cases, these are Funds of Funds (FoF) and charge a higher fee. What is the point of paying a higher fee when a large percentage gets invested in Indian securities? If an Indian investor wants exposure to Indian securities, he can do it via direct stock or mutual funds at a much lower cost.

Furthermore, there is an issue around taxation. The tax rate on capital gains from the sale of mutual funds varies depending on the type and the holding period. For equity-oriented schemes, capital gains are considered short-term if the investment is held for less than 12 months. For debt funds, the holding period for short-term capital gains is 36 months.

Now, you should know that gains from international mutual funds fall under section 50AA of the Income Tax Act of 1961. These are treated as debt funds and taxed similarly to debt mutual funds at the individual’s income tax slab rate. Previously, long-term capital gains from international funds were taxed at 20% with indexation benefits. In contrast, for domestic mutual funds with over 65% equity allocation, short-term capital gains on these investments are taxed at 15% without indexation, and long-term capital gains are taxed at 10%, with no tax on capital gains up to Rs 1 lakh.

Therefore, from a tax perspective, it is more advantageous to invest in domestic mutual funds than in FoFs with more than 20% exposure to Indian securities.

What proposals has SEBI listed?

Here are the different aspects of the SEBI's proposal:

• SEBI has proposed permitting mutual funds to invest in overseas mutual funds that invest a specific portion of their assets in Indian securities. However, the total exposure to Indian securities by such overseas funds is capped at 20% of their total exposure.
• Indian mutual fund schemes must ensure that all investors’ contributions to overseas mutual funds are combined into a single investment vehicle without any side vehicles. The corpus of an overseas mutual fund must be a blind pool. What does blind pool mean? It means it should have a common portfolio with no segregated portfolios, ensuring all investors have equal and proportionate rights in the fund.
• Next, SEBI recommended prohibiting advisory agreements between Indian mutual funds and the underlying overseas mutual funds to prevent conflicts of interest.

The result of breaching the set investment limits

After going through all the details, the obvious question is - what happens if the mutual fund invests in a foreign fund with exposure to Indian securities of more than 20%?

If that happens, SEBI will consider it a non-compliance thing. If the exposure increases more than the 20% limit, an observance period of 6 months will be allowed for the mutual fund schemes to monitor the portfolio rebalancing activities of the overseas mutual fund.

The biggest problem for the mutual fund and investors would be this - the Indian mutual fund should not make new investments in the overseas mutual fund. The new investments can only happen when the exposure to Indian securities by the overseas mutual fund falls back below the 20% threshold.

Also, if the portfolio remains unbalanced within the observation period of 6 months, the Indian mutual fund will have to liquidate its investment in the overseas instrument within six months. On top of it, the fund would not be allowed to accept any fresh subscriptions to the scheme, launch any new scheme, or levy any exit load on its investors exiting the scheme.

Benefit to Indian Mutual Funds

Here are some benefits of this proposal to Indian mutual funds:

• Enhanced Diversification: It allows Indian mutual funds to offer exposure to a wider range of international assets beyond just Indian securities to investors. Investors can benefit from the potential growth of foreign markets while maintaining some exposure to familiar Indian companies.
• Cost-Effectiveness: By allowing investment in overseas FoFs with some Indian exposure, SEBI might be aiming to provide a more cost-efficient way to achieve international diversification compared to directly investing in individual foreign stocks. FoFs typically have economies of scale, which can reduce overall fees.
• Meeting Investor Demand: There is growing investor interest in international diversification. The move may allow mutual funds to cater to that demand by offering new products that combine international exposure with some Indian investment.

Before you go

The details shared above are not final. The proposal is still under review, and SEBI is seeking public comments until June 7, 2024. The final regulations might have additional details and conditions for such investments. The SEBI's proposal has the potential to provide Indian mutual funds with greater flexibility in offering internationally diversified investment options to their investors. However, it is essential to remember that international investments carry additional risks like currency fluctuations and geopolitical instability.