Mumbai: Indian equity hedge funds are in a spot following a clarification issued by the capital markets regulator on their portfolio composition that could require them to cut exposure to their best performing stocks. According to Securities and Exchange Board of India rules, category III Alternative Investment Funds, also known as hedge funds, cannot invest more than 10% of their portfolio in a single stock. These are products for the rich with a minimum investment requirement of ₹1 crore.
On November 22, the regulator issued a clarification on the concentration norms wherein it brought the concept of 'passive breach'. Normally, if a fund buys shares of a company that exceed the 10% limit, it is construed as an 'active breach'.
However, rules could be inadvertently breached if a handful of stocks in the portfolio run up faster than the rest, resulting in their weights in their portfolio going above 10%. This is considered a passive breach and AIFs will now have to divest the excess stake within 30 days from the date of the breach, according to the circular.
Consider an AIF that has invested in 10 stocks equally wherein the fund owns 10% stake in each of the companies in its portfolio. Now say, only two of the 10 portfolio stocks are doing well while the other eight have fallen significantly. This disparity in the performance of stocks could potentially lead to a situation where the two well-performing stocks will exceed the 10% cap. Sebi now wants the AIFs to trim the exposure to the performing shares that will bring their stakes within the 10% threshold allowed as per the norms.
AIFs said the passive breach rule could adversely impact them in challenging market conditions. They are expected to approach Sebi later this week seeking to ease the rule. AIF managers were not willing to comment citing sensitivity of the matter.
According to Tejesh Chitlangi, partner, IC Universal Legal, if a listed stock is performing relatively well compared to other securities in aggregate portfolio, the value of the better performing stock may go beyond 10% of net asset value (NAV) and the fund manager now will have to appropriately cut the exposure to the better performing stock.
"The diversification requirement was to ensure limited risk concentration in a stock so that its failure doesn't negatively impact the overall portfolio by much but the new norm on rebalancing a more profitable stock may prove to be counter-productive and hurt investor interest," he said.
These norms will only apply to category III AIFs which are also called hedge funds. These funds are allowed to invest only in listed securities.
Experts said such rebalancing could lead to higher tax outgo. Profits derived from selling of shares are subject to capital gains tax. If the securities are held for less than a year, it is considered short-term capital gains and taxed at 15% slab. However, if they are held for more than a year, the gains are considered long-term capital gains and are taxed at 10% slab. Now, if a fund manager is forced to sell the shares within a year of buying due to passive breach, it would mean higher tax outgo.
"The rules may also result in forced payment of a higher short-term capital gains tax instead of potentially a lower long-term capital gains tax, if the rebalancing requires an early part exit," said a lawyer with direct knowledge of the matter. "There are also other charges such as stamp duty and securities transaction tax(STT) that will be applicable on such sales."
On November 22, the regulator issued a clarification on the concentration norms wherein it brought the concept of 'passive breach'. Normally, if a fund buys shares of a company that exceed the 10% limit, it is construed as an 'active breach'.
However, rules could be inadvertently breached if a handful of stocks in the portfolio run up faster than the rest, resulting in their weights in their portfolio going above 10%. This is considered a passive breach and AIFs will now have to divest the excess stake within 30 days from the date of the breach, according to the circular.
Consider an AIF that has invested in 10 stocks equally wherein the fund owns 10% stake in each of the companies in its portfolio. Now say, only two of the 10 portfolio stocks are doing well while the other eight have fallen significantly. This disparity in the performance of stocks could potentially lead to a situation where the two well-performing stocks will exceed the 10% cap. Sebi now wants the AIFs to trim the exposure to the performing shares that will bring their stakes within the 10% threshold allowed as per the norms.
AIFs said the passive breach rule could adversely impact them in challenging market conditions. They are expected to approach Sebi later this week seeking to ease the rule. AIF managers were not willing to comment citing sensitivity of the matter.
According to Tejesh Chitlangi, partner, IC Universal Legal, if a listed stock is performing relatively well compared to other securities in aggregate portfolio, the value of the better performing stock may go beyond 10% of net asset value (NAV) and the fund manager now will have to appropriately cut the exposure to the better performing stock.
"The diversification requirement was to ensure limited risk concentration in a stock so that its failure doesn't negatively impact the overall portfolio by much but the new norm on rebalancing a more profitable stock may prove to be counter-productive and hurt investor interest," he said.
These norms will only apply to category III AIFs which are also called hedge funds. These funds are allowed to invest only in listed securities.
Experts said such rebalancing could lead to higher tax outgo. Profits derived from selling of shares are subject to capital gains tax. If the securities are held for less than a year, it is considered short-term capital gains and taxed at 15% slab. However, if they are held for more than a year, the gains are considered long-term capital gains and are taxed at 10% slab. Now, if a fund manager is forced to sell the shares within a year of buying due to passive breach, it would mean higher tax outgo.
"The rules may also result in forced payment of a higher short-term capital gains tax instead of potentially a lower long-term capital gains tax, if the rebalancing requires an early part exit," said a lawyer with direct knowledge of the matter. "There are also other charges such as stamp duty and securities transaction tax(STT) that will be applicable on such sales."
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