In an attempt to manage the volatile capital flows, the finance ministry on Monday allowed foreign individuals to invest up to $10 billion in domestic mutual funds.
The Securities and Exchange Board of India will notify the rules by August 1.
The move was announced in the Budget.
At present, besides resident Indians, only foreign institutional investors, sub-accounts registered with Sebi and non-resident Indians can invest in mutual funds in India.
The move will give mutual funds access to more foreign money. The fund industry, however, reacted with caution and said it would wait for the final guidelines.
The move comes at a time the government is finding it difficult to fund its current account deficit due to volatile capital flows and higher imports.
Foreign retail participation in mutual funds may address the balance of payments problem by bringing in more stable funds and reducing the dependence on FII inflows, which are volatile.
The entry of foreign investors may add another Rs 45,000 crore ($10 billion) to mutual funds' assets under management of Rs 7,31,448 crore (Rs 7,314.48 billion).
Out of this, Rs 1,92,087 crore is invested in equity.
The investment limit could be increased if inflows were good and did not fluctuate much, said officials.
"We are willing to review the limit after six months, if required.
"It will be a guard against volatility as retail investors stay invested for the long term. So, it will increase the depth of the market," said Thomas Mathew, joint secretary, capital markets, finance ministry.
The new class of investors, called qualified foreign investors, will be able to invest through the depository participant route as well as the unit confirmation receipt
system, which will involve custodians.
In the first option, a QFI will open a demat account with a depository in India and buy units. In the second option, an investor will place an order with an overseas depository, which will then transfer it to a custodian bank in India for buying the units.
QFIs can be individuals and bodies, including pension funds. Fund houses will be responsible for deducting tax at source.
The industry reacted with caution. Executives said the move could be a game changer but added they would have to first see the final guidelines to judge its impact.
Sundeep Sikka, chief executive officer, Reliance Mutual Fund, said, "It's a step in the right direction and will contain volatility. It is not only good for asset management companies but also for the capital markets."
Arindam Ghosh, chief executive officer, Mirae Asset Global Investment (India), said, "The government has kept a reasonable limit. This has an explosive potential, but we are waiting for the final guidelines." He said the move would lower the volatility in fund flows.
"The churn ratio in India is higher than the global figure. We have to see how stable funds from foreign individual investors are," he said.
A section of fund managers said the decision to put a cap was premature. "It is not possible for domestic fund managers to sell products overseas given the regulatory hurdles in other countries," said the chief investment officer of one of the top ten fund houses in the country.
"It will not give a major boost to domestic fund houses. I suspect this route will be used by Indians to bring black money into the country," said an industry veteran.
The chief executive of a mid-sized fund house said the industry was likely to see a lot of volatility in fund flows, leading to underperformance of mutual funds.
He added the decision could impact other investors too.