Taxmann's Analysis | SEBI's Overseas Investment Guidelines for Indian Mutual Funds

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SEBI’s Overseas Investment Guidelines for Indian Mutual Funds

1. Introduction

SEBI has released a consultation paper on easing investments by Indian mutual funds in overseas funds. The objective of the consultation paper is to seek public comments on the proposal to ease investments by Indian mutual funds in overseas mutual funds (MFs)/unit trusts (UTs) that invest a certain portion of their assets in Indian securities. Therefore, comments from the public are invited. The same may be submitted by June 7th, 2024.

2. Need for Consultation Paper

2.1. Current Investment Norms for Mutual Funds

Under the current regulatory framework, SEBI-registered Mutual Funds can invest in certain eligible overseas securities. These include the following:

(a) American Depositories Receipts (ADRs)/Global Depositories Receipts (GDRs) issued by Indian or foreign companies

(b) Equity of overseas companies listed on recognized stock exchanges overseas

(c) Initial and follow-up public offerings for listing at recognized stock exchanges overseas

(d) Foreign debt securities in the countries with fully convertible currencies, short-term as well as long-term debt instruments with a rating not below investment grade by accredited/registered credit rating agencies

(e) Money market instruments rated not below investment grade

(f) Repos in the form of investment, where the counterparty is rated not below investment grade. The repos should not, however, involve any borrowing of funds by mutual funds

(g) Government securities where the countries are rated not below investment grade

(h) Derivatives traded on a recognized stock exchange overseas only for hedging and portfolio balancing with underlying securities

(i) Short-term term deposits with banks overseas where the issuer is rated not below investment grade

(j) Units/securities issued by overseas Mutual Funds or Unit Trusts (MF/UTs) registered with overseas regulators and investing in:

• Aforesaid securities

• Real Estate Investment Trusts (REITs) listed in recognized stock exchanges overseas or

• Unlisted overseas securities (not exceeding 10 per cent of their net assets).

2.2. Issue Under the Current Norms and Rationale Behind the Proposal

The current framework does not specifically permit Indian Mutual Funds to invest in overseas mutual funds/unit trusts that have exposure to Indian securities. This limitation has led many mutual funds in the industry to avoid such investments. The proposed changes address this issue and provide more opportunities for Indian mutual funds.

Ambiguity regarding investments in overseas funds that may invest a certain portion of their funds in Indian securities deters Mutual Funds from investing in those overseas MF/ UTs, ETFs and index funds that invest in a basket of countries, including India.

The market data reflects the lower investment percentage in Indian Securities. For example, the MSCI Emerging Markets Index had an 18.08% weightage to Indian securities as of April 30th, 2024. Similarly, JP Morgan’s Emerging Markets Opportunities Fund held approximately 15% in Indian investments as of March 31st, 2024.

SEBI, to facilitate investments in such overseas MFs/UTs, proposes to permit Indian Mutual Funds to invest in such overseas MFs/UTs that have a certain limited exposure to Indian securities.

Further, adequate safeguards for such investments would keep Indian Fund of Funds (FoFs) true to their label and enable investors to take desired exposure to overseas securities.

3. SEBI’s Proposal

After careful consultation with stakeholders and the Mutual Fund Advisory Committee (MFAC), SEBI has proposed to allow Indian mutual funds to invest in overseas MFs/UTs that invest a particular portion of their assets in Indian securities. This proposal is subject to the condition that the total exposure to Indian securities by such overseas funds should not exceed 20% of their net assets, ensuring a balanced and controlled approach.

3.1. Guidelines for Investing in Overseas MFs/UTs

While investing in overseas MFs/UTs, the Indian mutual fund schemes must ensure the following:

(a) Pooling – The contribution of all investors in an overseas MF/UT is pooled into a single investment vehicle without any side vehicles.

(b) Pari-passu and Pro-rata Rights – The corpus of an overseas MF/UT must be a blind pool (i.e. common portfolio) with no segregated portfolios. All investors in the overseas MF/UT must have pari-passu and pro-rata rights in the fund, i.e. they must receive a share of returns/gains from the fund in proportion to their contribution.

(c) Independent Investment Manager/Fund Manager – An officially appointed, independent investment manager/fund manager must manage the overseas MF/UT and actively make all investment decisions for the fund. This ensures that the investments are made autonomously by the investment manager/ fund manager without influence from investors or undisclosed parties.

(d) Public Disclosure – The overseas MFs/UTs must periodically disclose their portfolios to the public to maintain transparency.

(e) No Advisory Agreement – To prevent conflicts of interest and avoid undue advantage, advisory agreements must not exist between Indian mutual funds and underlying overseas MFs/UTs.

3.2. Consequences of Breach of Exposure Limit

The total exposure to Indian securities by overseas funds should not exceed 20% of their net assets, ensuring a balanced and controlled approach. SEBI specifically mentioned that if the exposure to Indian securities by overseas mutual funds/unit trusts is above 20% at the time of investing (both fresh and subsequent), it shall be considered noncompliance.

However, if the exposure to Indian securities exceeds 20% of their net assets after investing in an overseas fund, an observance period of 6 months must be permitted for the Indian

mutual fund schemes to monitor any portfolio rebalancing activity by the underlying overseas MF/UT.

Further, during the observance period, the Indian Mutual Fund scheme must not undertake fresh investments in overseas MF/UT. It may resume its investments if the exposure to Indian securities by such overseas MF/UT falls below the 20% limit.

3.3. Norms w.r.t Rebalancing of the Portfolio

Suppose the underlying overseas MF/UT portfolio is not rebalanced within the 6-month observance period. In that case, the Indian Mutual Fund scheme must liquidate its investments in the concerned underlying overseas MF/UT within the next six months (‘liquidation period’) from the end of the observance period.

Further, suppose during the liquidation period, the exposure to Indian securities by the underlying overseas MF/UT falls below the prescribed limit of 20%. In that case, the requirement for the Indian Mutual Fund to liquidate its investments does not apply.

3.4. Consequences of Failure to Rebalance

If the Indian Mutual Fund/Asset Management Company fails to rebalance the scheme’s portfolio within the 6 months, then after the 6-month liquidation period, the Indian Mutual Fund/Asset Management Company must not be permitted to accept any fresh subscriptions in the concerned Indian Mutual Fund scheme.

Further, the Indian Mutual Fund/Asset Management Company must not be permitted to launch any new scheme and levy exit load, if any, on the investors exiting such schemes.

Comments

The allocation to Indian securities has steadily increased from approximately 8% in March 2018 to 15.88% in October 2023. Given the country’s robust economic prospects, further increases in allocation by overseas funds and indices are anticipated.

The proposed allowance for Indian mutual funds to invest in overseas funds is expected to diversify portfolios and enhance growth opportunities for Indian investors. This initiative will give investors broader exposure to international markets, improving their ability to diversify and manage risk. Additionally, this move aims to attract foreign investment into Indian mutual funds, thereby boosting market confidence and liquidity.

Public comments on this proposal are invited and should be submitted no later than June 7th, 2024. Comments can be submitted through an online web-based form available at the following link: SEBI Public Comment Submission