BRIDGING THE GAP: ANALYSING SEBI'S SPECIALIZED INVESTMENT FUNDS (SIFS) AND REGULATORY CHALLENGES

This post is authored by Anany Tiwari, B.A. LL.B. (Honours) student at HNLU, Raipur.

1. INTRODUCTION

The Securities and Exchange Board of India (SEBI) has introduced Specialized Investment Funds (SIF) a new asset class under the SEBI (Mutual Funds) Regulation, 1996, to bridge the gap between Mutual funds (MFs) and Portfolio Management Services (PMS). It  provides a comprehensive regulatory framework for SIFs (SIF Regulatory Framework). This framework intends to promote flexibility in investment strategies while maintaining a structured approach. SIFs are introduced to cater to high-net-worth individuals and sophisticated investors by allowing asset management companies (AMCs) to design investment strategies that allow for higher risk exposure, active asset allocation, and structured redemption mechanism. 

While this regulation aims to bridge the gap between MFs and PMS by offering dynamic investment strategies, it also has certain lacunas that can be exploited. This article aims to bring forward these lacunas and provide recommendations to fill the gaps. 

2. AMBIGUITY IN BRANDING AND ADVERTISEMENT

The AMCs must ensure that the SIFs have a separate and different identity from the MFs. This also requires  that the SIFs have a separate brand name and logo than  MF. However, to ensure that the SIFs gain some reputation, the AMCs are allowed to use the MFs' brand name in the offer documents, advertisements 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 safeguards to prevent undue influence of MFs over the SIFs, some fundamental challenges exist regarding investor confusion. First, while the scheme-related document would be distinct for the MFs and SIFs, outlining the risk associated with them, but  allowing limited association of the MFs in advertisement for five years may create an impression that the associated risks are comparable for both of the products. Second, although there is a mandate that the MFs 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 emphasize the MF brand while making the SIF branding secondary.

To ensure that the investors make an informed choice, it is necessary to reduce the transition period from five years to two or three years.  A prolonged period of five creates familiarity bias, making it difficult for the investors to distinguish between SIFs and MFs over time. By reducing the transition period to two or three years, it can be ensured that the investors decide to invest based on their understanding rather than associating SIFs with the brand of MFs. Additionally, there is a need for stricter visual differentiation guidelines to ensure that there is distinct branding of SIFs by using different color 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.

3. MINIMUM INVESTMENT THRESHOLD ENFORCEMENT ISSUES

The minimum threshold across all investment strategies under SIFs is ten lakh rupees to ensure that only sophisticated investors participate in the SIFs. Systematic investment plans (SIPs) are permitted; this allows investors to contribute smaller amounts periodically. 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 ₹10 lakh due to such fluctuations.

Allowing SIPs can bypass the upfront minimum investment threshold, as SIPs allow the investors to accumulate the required ten lakh 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. Further, if the holdings fall below the minimum requirement due to NAV fluctuations, the investors cannot redeem partially; this would lead to constraints in liquidity as investors can either exit completely or remain Locked.

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

4. INVESTMENT STRATEGY AND RISK MITIGATION GAPS

SEBI has introduced several methods that help in mitigating the risk that arise while dealing in SIFs. First, short exposure through derivatives is capped at 25%, This means that a 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 SIF framework combine investments in equity, debt, and other asset classes while allowing limited short exposure through derivatives.

Despite these safeguards, there are several loopholes which be potentially exploited and consequently  lead to an excessive risk-taking and investor losses. The 25% cap on short exposure does not prevent excessive leverage, fund managers can manipulate this using complex derivatives strategies to amplify risk while staying within the limit on the paper. Further, there are no explicit risk reduction methods, unlike other regulated investment vehicles, in case of a sharp market downturn. Lastly, while the Hybrid investment strategies allow for dynamic asset allocation, there are no safeguards for preventing excessive rebalancing, which could increase transaction costs.

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. Further, for sharp market downturns, circuit breakers should be triggered when the market is volatile beyond a certain point; this would prevent further trading.

5. REGULATORY ARBITRAGE BETWEEN SIFS AND AIFS

Alternative Investment Funds (AIFs) share similarities with SIFs that could lead to potential regulatory arbitrage. Investors looking to avoid stricter AIF regulations 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 requirement under AIF regulations. This would lead to market misalignment as the investors who would typically invest in AIFs (that have stricter regulations) may invest in SIFs without fully understanding the risks associated with it. To avoid this regulatory arbitrage, SEBI should ensure that SIFs are not acting as AIFs lite by prohibiting certain AIFs from being packed as SIFs.

6. CONFLICT OF INTEREST AND RESOURCE SHARING

The framework allows AMCs to share infrastructural and operational resources between their MFs and SIFs schemes. Further, Fund Managers are permitted to manage portfolios for both SIFs and MFs simultaneously. while the approach appears to be practical in terms of saving costs and increasing efficiency, it can also lead to a potential conflict of interest among the investors. 

The primary concern is that the fund managers might prioritise SIFs, which are designed for High Net Worth Individuals (HNIs), over retail MF investors. The rationale behind this concern is that the structural incentives may lead to a subtle preferential treatment. SIFs allow for greater flexibility in investment strategies, including higher risk exposure and active asset allocation, which may attract fund managers seeking to maximize returns through more sophisticated strategies. Further, the sharing of resources may lead to Cross-Trading, 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.

To fill these lacunas, 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.

7. CONCLUSION

SIFs offer a vital bridge between Mutual Funds and PMS, but regulatory gaps persist. Issues such as branding ambiguities, investment threshold enforcement, risk exposure, regulatory arbitrage, and conflicts of interest require a strict oversight. SEBI must refine regulations to enhance investor protection, enforce stricter risk controls, and prevent misuse. Strengthening safeguards will ensure SIFs fulfil their intended role while maintaining market integrity.