How Regular Mutual Funds Work, and What They Cannot Do

Part 2 of 6 in the Specialised Investment Funds series: Part 1 · Part 3 · Part 4 · Part 5 · Part 6

Before we understand what Specialised Investment Funds (SIFs) are, we need to understand what they are not, and why regular mutual funds, for all their benefits, have a structural limitation baked into their design.

The Basic Idea of a Mutual Fund

A mutual fund is elegantly simple. Thousands of investors pool their money together. A professional fund manager invests that pool in stocks, bonds, or a mix of both. Each investor owns a proportional slice, called units, and the value of each unit rises or falls based on the value of the underlying investments.

This value per unit is called the Net Asset Value or NAV.

If you invest ₹1 lakh in a fund with NAV of ₹50, you get 2,000 units. If the portfolio grows and NAV rises to ₹60, your 2,000 units are now worth ₹1.2 lakh. You have made ₹20,000.

Simple, transparent, and regulated. This is why mutual funds have become the savings vehicle of choice for millions of Indian households.

The "Long-Only" World

Here is the structural limitation. A regular equity mutual fund can only do one thing with stocks: buy them.

The fund manager might love Infosys and buy a lot of it. She might be neutral on HUL and buy less. She might dislike Asian Paints and simply choose not to buy it. But "not buying" something is very different from actively profiting when its price falls.

In the language of markets, regular funds can only go long. They are entirely dependent on markets going up.

When markets fall — as they did in 2008, in 2020, and during many corrections in between — an equity fund can only hold on and wait. The best a fund manager can do is move some money to cash or bonds to reduce losses. She cannot use her negative conviction on a stock to generate returns.

Consider this: if a fund manager is absolutely certain that Company X is overvalued and its stock will fall 30% in the next year, she can do exactly nothing with that insight, except avoid owning it. Meanwhile, that falling stock drags down the index and pulls down her fund's returns too.

A Typical Portfolio Breakdown

Pick any large diversified equity mutual fund in India, and its portfolio looks roughly like this:

The small cash portion is not idle. It earns short-term returns (through instruments like Treasury Bills or overnight lending called TREPS) while being available to buy more stocks when opportunities arise, or to pay investors who want to exit.

The fund's job is straightforward: identify the best companies, buy their stocks, and hold. When the market rises, the fund rises. When the market falls, the fund falls. The fund manager adds value by picking better stocks than the index, but she is still riding the same wave as the market.

The Index Problem

This has a deeper implication. Most equity funds in India closely track the overall stock market index — the Nifty 50 or the BSE Sensex. On a day the Nifty falls 3%, most equity funds also fall roughly 3%. The fund manager's skill might reduce this to a 2.5% fall, but she cannot make the fund rise on a falling market day.

This is called market risk or beta: the exposure to overall market movement that every long-only investor carries and cannot escape.

Sophisticated investors — particularly high-net-worth individuals and family offices managing large portfolios — have long sought investment strategies that are less correlated to overall market direction. Strategies that can generate returns whether the market goes up, sideways, or even down.

This is exactly what hedge funds do in developed markets. They go both long and short, buying stocks they believe will rise and short-selling stocks they believe will fall.

Until 2024, Indian mutual fund investors had no access to such strategies within the regulated mutual fund framework. You either invested in long-only funds, or you stepped outside the mutual fund universe entirely.

Enter SEBI's Specialised Investment Fund

In 2024, the Securities and Exchange Board of India (SEBI) introduced a new mutual fund category called the Specialised Investment Fund, or SIF.

The SIF is built on the same foundation as a regular mutual fund: pooled money, professional management, SEBI regulation, daily NAV disclosure. But it adds one major new capability: the ability to take short positions using futures and options.

This means a SIF fund manager can now profit from a stock falling, not just from a stock rising. She can use her negative conviction, not just her positive conviction, to generate returns.

But SIFs come with important conditions. They are not available to all investors. The minimum investment is ₹10 lakh. They are designed for investors who understand the risks of derivatives and can absorb the complexity that comes with them.

In the next article, we will look at exactly how a SIF is structured, what it holds, how it combines long positions with short positions, and how to read its portfolio like a professional.

Next: Part 3 — Inside a Specialised Investment Fund: How It Is Built and What It Looks Like →

Investments in mutual funds are subject to market risks. This article is for educational purposes only and does not constitute investment advice.