SEBI’s Specialised Investment Funds (SIFs): Addressing Market Gaps Amid Regulatory Uncertainties

Introduction

To bridge the gap between mutual funds (MFs) and portfolio management services (PMS), the Securities and Exchange Board of India (SEBI) has introduced specialised investment funds (SIF) as a new class of asset under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996¹, the Notification² aims to provide a comprehensive regulatory framework for governing SIFs and intends to promote flexibility in investment strategies while maintaining a structured approach. SIFs are introduced to cater to high-net-worth individuals (HNIs) and sophisticated investors by allowing ssset management companies (AMCs) to design investment strategies for higher risk exposure, active asset allocation, and structured redemption mechanisms. MFs provide investors with reliable options to invest but are not suited for investors willing to take higher risks. For personalised investment options and higher risks, Indian investors’ have PMS. However, the problem with PMS is the high minimum investment threshold. On the other hand, the SIFs unlike MFs allow investors to take higher risks without a high minimum investment threshold like PMS.

While this regulation aims to bridge the gap between MFs and PMS by offering dynamic investment strategies, the proposed framework is not free from defects and hence it ignites a possible discourse over its course correction in the near future.

This article aims to bring forward the ambiguity in branding and advertisement, enforcement issues with minimum investment threshold, investment strategy and risk mitigation, regulatory arbitrage between SIFs and alternative investment funds (AIFs), and conflict of interest in resource sharing.

Branding ambiguities: Risks of misrepresentation and investor deception

It is pertinent to mention that the regulation provides that AMCs have to ensure that the distinct identity of SIFs is separate from that of MFs. This is to be done by ensuring that the SIFs have an individual brand name and logo from MF. However, to ensure that the SIFs gain some reputation, the AMCs can use the MFs’ brand name in the offer documents, advertisement, and promotional material for five years. Further, to avoid undue influence, the MFs’ brand name should be equal to or smaller than the font of the brand name of the SIFs in all the offer documents and promotional material.

Despite these provisions to prevent undue influence of MFs over the SIFs, some fundamental challenges exist. First, allowing the MFs’ brand name to be used in marketing material for five years creates the potential to create a false impression in the minds of retail investors that these SIFs provide similar risk levels and regulatory protections as that of traditional MFs. Second, while there is a mandate that the MF font size is to be smaller than or equal to the size of the SIFs brand name, this can be easily manipulated. Typography, font placement, colour contrast, and design techniques can be used to emphasise the MF brand while making the SIF branding secondary. Thus, this manipulation may lead to deception among investors.

Minimum investment rule: Gaps and liquidity risks

The minimum threshold across all investment strategies under SIFs is ten lakh rupees to ensure that only sophisticated investors participate in the SIFs. Strikingly, the SIF framework allows systematic investment plans (SIPs) which enable investors to contribute smaller amounts periodically.³ Further, passive breaches in the minimum investment threshold due to the fluctuations in net asset value (NAV) are not treated as violations, but investors cannot make partial redemptions if their holdings fall below Rs 10 lakhs due to such fluctuations.

Allowing SIPs can bypass the upfront minimum investment threshold⁴, as SIPs allow the investors to accumulate the required ten lakhs investment gradually. This undermines the intent of the regulation as the persons who do not have the minimum investment in liquid capital can still gain exposure to SIFs, especially the retail investors who might invest in SIFs without understanding the risks involved and risking their hard-earned money. Further, if the holdings fall below the minimum requirement due to NAV fluctuations, the investors cannot redeem partially; which would in turn lead to liquidity constraints because investors can either exit completely from the SIF or their total investment remains locked within it.

Risk management in SIFs: Hidden vulnerabilities

While investment strategies are the core of the framework, risk mitigation forms an indispensable part of the SIF landscape. SEBI has introduced several methods that help in mitigating the risks that arise while dealing with SIFs. First, short exposure through derivatives is capped at 25%, which means that an SIF cannot take short positions through derivatives exceeding 25% of the net asset. Second, SIF allows for the offsetting of certain derivative positions against each other in the same underlying asset to manage and reduce risk. Lastly, hybrid investment strategies under the framework combine investments in equity, debt, and other asset classes while allowing limited short exposure through derivatives.

Despite these safeguards, several loopholes can be potentially exploited which could lead to excessive risk-taking and investor losses. The 25% cap on short exposure does not prevent excessive leverage, fund managers can still manipulate this using complex derivatives strategies to amplify risk while staying within the limit on the paper. Further, in case of a sharp market downturn, the provision of the Regulations lacks explicit risk reduction methods⁵, unlike other regulated investment vehicles⁶.

Regulatory arbitrage and conflict of interest

At the outset, alternative investment funds (AIFs) share similarities with SIFs⁷ that could lead to regulatory arbitrage. Investors looking to avoid stricter AIF Regulations⁸ would shift from AIFs to SIFs since they offer more portfolio flexibility than MFs and lower regulatory restrictions than AIFs. Investors would choose SIFS over AIFS despite their strategy would be more suited for AIFS because of the flexibility in redemption that SIFs offer compared to stricter regulatory requirements under AIF Regulations. This would lead to market misalignment as the investors who would typically invest in AIFs will shift to SIFs without fully understanding the risks associated with it. To avoid this regulatory arbitrage, SEBI has to ensure that SIFs are not acting as AIFs lite by prohibiting certain AIFs from being packed as SIFs.

The framework allows AMCs to share infrastructural and operational resources between their MFs and SIFs schemes. Further, fund managers are allowed to manage portfolios for both SIFs and MFs at the same time. This could lead to the retail investor’s interest being ignored as the SIF focuses on the HNIs, and AMCs may prioritise SIF portfolios over retail mutual fund investors. Further, the sharing of resources may lead to cross-trading⁹, which could lead to trading in such a manner that it benefits one fund over another. This raises concerns about price manipulation, unfair asset transfers, and conflicts of interest where SIFs could receive preferential execution of trades, leaving retail MF investors at a disadvantage.

Possible solutions to enhance the framework

To ensure that the investors make an informed choice, it is necessary to ensure that the transition period of five years is reduced to two or three for allowing the use of the MF name for advertising. There is also a need for stricter visual differentiation guidelines to ensure that there is distinct branding of SIFs by using different colour schemes, logos, and standard disclaimers in bold fonts to explicitly distinguish SIFs from MFs. Further, the advertisements must include a disclaimer that states SIFs are not the same as MFs and involve higher risks.

To overcome the constraints related to the minimum investment threshold, there should be a requirement to prohibit SIPs or enforce an upfront commitment of Rs 10 lakhs. If SIPs are permitted, it should be mandated for the investors to invest Rs 10 lakhs within a defined period; this would ensure compliance with the regulations’ intent. Further, if the holding falls below Rs 10 lakhs, SEBI should allow partial redemption with a condition that they restore the investment to Rs 10 lakhs within a specified time. Partial redemption with a restoration requirement would balance liquidity needs with regulatory objectives.

Further, to prevent excessive risk-taking, SEBI should require SIFs to maintain higher margin levels for unhedged short positions. Maintaining a higher margin would ensure that the funds engaging in risky derivative trades have sufficient capital buffers to absorb losses and prevent excessive leverage. For sharp market downturns, circuit breakers¹⁰ should be triggered when the market is volatile beyond a certain point; this would prevent further trading.

Additionally, to fill the lacunas relating to resource sharing, there should be a strict separation of decision-making and operational processes between MFs and SIFs. The trading and execution process should be independently monitored to ensure that SIFs are not given any preferential treatment over MFs. Further, independent fund managers should be appointed.

Conclusion

The introduction of SIFs by SEBI marks a significant step in bridging the gap between MFs and PMS. While the framework offers enhanced flexibility for sophisticated investors, several regulatory gaps persist. Issues surrounding branding ambiguities, enforcement of minimum investment thresholds, risk exposure, regulatory arbitrage, and conflicts of interest pose potential challenges to market integrity. Addressing these concerns through stricter oversight, enhanced transparency, and well-defined risk mitigation strategies is essential. By refining the regulations, SEBI can ensure that SIFs achieve their intended purpose, providing investors with a structured yet dynamic investment option, while upholding investor protection and financial stability.