The story so far: Markets regulator Securities and Exchange Board of India (SEBI) on May 17 floated a consultation paper proposing a framework for facilitating investments by domestic mutual funds (MFs) in their overseas counterparts, or unit trusts (UTs) that invest a certain portion of their assets in Indian securities. It observed that the existing framework does not explicitly permit domestic MFs to invest in overseas MF/UTs with exposure to Indian securities. “Therefore, it is understood that many mutual funds in the industry avoid investing in such overseas MF/UTs that have any kind of exposure to Indian securities,” it said. Comments about the proposed framework are solicited until June 7.  

What is the purpose of the proposed framework?  

Noting India’s strong economic growth prospects, SEBI observes that Indian securities offer an attractive investment opportunity for foreign funds. SEBI says this has led to several international indices, exchange traded funds (ETFs), MFs, and UTs allocating a part of their assets towards Indian securities. For perspective, in a consultation paper, MSCI Emerging Markets Index was noted to hold 18.08% exposure to Indian securities. Similarly, JP Morgan’s Emerging Markets Opportunities Funds held 15% in Indian investments, as per their latest factsheet (as on March 31, 2024).

Indian mutual funds, somewhat conversely, diversify their portfolios by launching ‘feeder funds’ which invest in overseas instruments such as (units of) MF, UTs, ETFs and/or index funds. Other than diversification, it eases the path to make global investments. However, ambiguity remains about investments which have Indian exposures, which deters domestic MFs from investing in these instruments which in turn invest in a basket of countries as a means of diversification and enhancing returns.  

SEBI’s cumulative assessment sees merit in potentially allowing investments of this kind with “limited exposure to Indian securities.” Within the proposed framework, the markets regulator also intends to place essential safeguards which would keep the Indian instruments “true to their label” and enable investors to take desired exposure in overseas securities. It is essential to note that, if the fund has significant exposure to Indian securities, the purpose of making an overseas investment is defeated. Secondly, an indirect investment through an (indirect) overseas investing instrument is not cost-effective for an end-investor in comparison to a direct investment made in Indian securities — thus, fulfilling no purpose.  

What proposals has SEBI tabled?  

Significantly, the upper limit for investments made by overseas instruments (in India) has been capped at 20% of their net assets. That is, overseas instruments being considered must not have an exposure of more than 20% in Indian securities. Deeming the cap “appropriate,” SEBI explains that this would help “strike a balance between facilitating investments in overseas funds with exposure to India and preventing excessive exposure.” 

The markets regulator has also sought that Indian mutual funds ensure contributions of all investors of the overseas MF/UT is pooled into a single investment vehicle. They must not be in a side-vehicle, that is, a parallel instrument alongside the main instrument with varying exposure. This again is essential for the invested money (of these domestic mutual funds) to attain its objective. Other than this, Indian mutual funds must also ensure that all investors of the overseas instrument are receiving gains proportionate to their contribution – and in no order of preference.  

Other than this, Indian mutual funds would also have to ascertain that the overseas instrument is managed by an “officially appointed, independent investment manager/fund manager” who is “actively involved in making all investment decisions for the fund.” SEBI stresses that these investments are to be made autonomously by the manager without any influence from the investors or undisclosed parties.  

SEBI is also seeking public disclosures of the portfolios of such overseas MF/UTs periodically for the sake of transparency. Finally, it warns against the existence of any advisory agreement (business agreement) between the Indian mutual fund and the overseas MF/UT. This is to prevent conflict of interest and avoid any undue advantage.  

What happens when overseas instruments breach the limit?  

If the overseas instrument breaches the 20% limit, the Indian mutual fund scheme which is investing in the overseas fund would slip into a 6-month observance period. This period is to be utilised by the overseas fund to rebalance its portfolio adhering to the cap. During this time, the domestic mutual fund cannot undertake any fresh investment in the overseas MF/UT. Further investment in the overseas instrument would be allowed only when the exposure drops below the limit.  

If the portfolio is not rebalanced within the observation period, the Indian mutual fund must liquidate its investment in the overseas instrument within 6 months. It would not be permitted to accept any fresh subscriptions to the scheme (for the investment type to the overseas fund/UT/indices), launch any new scheme or levy any exit load (that is, the fee for redeeming the mutual fund before a specific date) on its investors exiting the scheme. 

Are there other considerations at play? 

The first consideration is RBI’s upper limit for overseas investment by mutual funds which was breached in June last year. RBI Governor Shaktikanta Das stated earlier in February that there was no proposal to increase the investment limit for mutual funds. He acknowledged that requests for relaxation were made by mutual funds and other players. In light of this, Suresh Soni, CEO at Baroda BNP Paribas Mutual Fund told The Hindu, “The changes to regulations would not have any practical impact immediately, as the overall industry limit for overseas investments is effectively exhausted.” 

The other part of it relates to potential appetite, especially for associated risks — especially for a potential spillover effect because of the global linkages.  

Finance Minister Nirmala Sitharaman speaking at a BSE event earlier this month, expressed confidence in the markets and observed household savings were increasingly moving to investing in the equity market. She stated that middle-class families realise that even if risk-laden, it offered better returns. The finance minister had also stated that unique mutual fund investors in the country had grown from 1 crore in 2014 to 4 crore today. Data from the Association of Mutual Funds in India (AMFi) further informs that asset under management (AUM) of the Indian MF industry has grown six-fold in a decade from ₹9.45 trillion as on April 30, 2014, to ₹57.26 trillion as on April 30, 2024. This is indicative of a potential appetite to engage with markets.  

Further, Mr. Soni says, investments in international markets provide diversification opportunities to Indian investors. He added that they also provide investment opportunities in sectors or industries that may not be available in the Indian listed market space. “Therefore, they are a useful avenue for diversifying investor portfolios as well as generating significant risk adjusted returns,” Mr. Soni reasoned.