SEBI permits equity funds to allocate up to 35 percent of residual portfolios to non-equity assets

The Securities and Exchange Board of India (SEBI) has introduced a regulatory update allowing equity funds to invest up to 35 percent of their residual portfolio in non-equity investments. The change impacts how active funds manage their allocations beyond their primary mandates.

Taking large-cap active funds as an example, regulations traditionally require them to invest a minimum of 80 percent of their assets in large-cap stocks. The remaining portion has historically given these funds room to allocate toward mid-cap and small-cap stocks. Under the new SEBI guidelines, these funds now have the flexibility to direct their residual allocations into alternative instruments such as gold ETFs, silver ETFs, and Infrastructure Investment Trusts (InvITs).

The underlying rationale for this inclusion is stability. Assets like gold and silver often perform well during periods of sharp equity market declines. By incorporating non-equity instruments, equity funds gain an additional mechanism to potentially stabilise portfolios when market volatility increases. However, whether individual equity funds choose to utilize this provision remains optional.

This regulatory flexibility introduces considerations for investors building core portfolios to achieve specific life goals. Investors often maintain distinct allocations across large-cap active funds, fixed-income instruments like bank deposits, and direct holdings in gold and silver ETFs. When a large-cap active fund introduces exposure to gold and silver ETFs within its residual portfolio, investors may inadvertently create an overlapping exposure to these metals through both direct holdings and indirect fund allocations.

While this non-equity allocation does not alter the tax treatment of investments in these equity funds, it can lead to skewed asset allocations if not monitored closely. Thus far, equity funds have largely maintained their traditional equity allocations despite the new regulation, though this pattern could shift over time.

Investors concerned about unexpected non-equity exposure within their equity funds have alternative investment avenues. Index funds and equity ETFs function as passive products that are required to mirror their specific benchmark indexes. Their portfolios contain the exact stocks and weights defined by the benchmark, ensuring that investors receive their intended, direct exposure to the equity index without extraneous asset classes.

"The recent regulatory update by SEBI introduces important flexibility for fund managers to navigate market volatility by utilizing non-equity instruments like gold and silver ETFs. However, for investors, this means portfolio monitoring becomes critical. When active funds blend alternative assets into their residual allocations, it can unintentionally skew pre-planned asset allocation strategies. Investors need to carefully evaluate their cumulative exposure across both direct holdings and mutual fund portfolios to ensure alignment with their financial goals." — Dr. Shishir Gupta, Founder & CEO, StartupLanes