Passively managed mutual funds, which include exchange traded funds and index funds, are an over ₹5 lakh crore business in India. Market regulator SEBI's latest circular on development of passive funds goes a long way in boosting the liquidity and investor-friendliness aspects of passive funds. The provisions of the circular will come into effect from July 1 and will be applicable to all existing ETFs/ index funds. Here are five key moves that investors need to know:

Lower concentration risk

Debt ETFs/index funds have been categorised based on indices comprising of (a) Corporate Debt Securities (corporate debt indices); (b) Government Securities (G-sec), t-bills and/or State Development Loans (SDLs) (G-sec indices); (c) A combination of Corporate Debt Securities and G-sec/t-bills/SDLs (Hybrid debt indices). This creates clear demarcation and will make it easier for investors to choose products based on their risk-return profile.

Besides, to help investors be shielded from concentration risks in each product, the SEBI has set in place a number of restrictions. Firstly, how much can one debt index invest in a single security has been mentioned with varying caps as per product nature. E.g. for an index with at least 80% weight of corporate debt securities, single issuer limit is 15% weight in respect of AAA rated securities, 12.5% in respect of AA rated securities and 10% in respect of A and below rated securities.

For an index based on G-Sec and SDLs, single issuer limit is not applicable, which is understandable given the quasi sovereign/sovereign nature of exposure which reduces the credit risk.

SEBI has also said that a debt ETF/index fund index shall not have more than 25% weight in a particular group — excluding securities issued by public sector banks (PSBs), PSUs and PFIs. In light of various corporate debt market turmoil witnessed over the years, such a group exposure cap will help ring-fence investors. Also, with the group cap regulation, debt ETFs / index funds will now be in line with other debt funds in the industry.

Better replication of indices

Replication of debt indices has been a tricky subject. The previous guidelines specified replication of indices at security or issuer-level by passive funds. The new norms focus more on duration, interest rate and credit risk-based replication. Also, at no point of time the securities of issuers not forming part of the index should exceed 20% of NAV. If ETFs/index funds replicate the underlying index properly and with low time lag, there will be minimal deviation from underlying benchmark and this will benefit passive investors.

In case of Target Maturity (or Target Date) ETFs/ index funds, a sub-segment that has been a lot of launches recently, the SEBI has provided graded norms for permissible deviation in duration (a measure of bond risk). This provides some leeway as the product comes near maturity.

Enhances liquidity for ETFs

Market maker plays an essential role in how an ETF trades and ensures the continued and efficient exchange of securities between buyers and sellers. They do this in multiple ways, including providing liquidity to the market by selling units to investors and purchasing units when investors sell. The SEBI in its latest circular has mandated each AMC to appoint at least two Market Makers (MMs), who are members of the stock exchanges, for ETFs to provide continuous liquidity on the stock exchange. Industry sources said that a lot of AMCs don't have 2 MMs currently and with specific regulations, things now have to be done officially.

In order to enhance liquidity in units of ETFs on stock exchange platform, the SEBI has decided that direct transaction with AMCs shall be facilitated for investors only for transactions greater than ₹25 crore. Earlier, there was no threshold.

However, do note that investors can directly approach the AMC for redemption of units of ETFs, for transaction of up to ₹25 crore, without any exit load, in case traded price (closing price) of the ETF units is at discount of more than 1% to the day end NAV for 7 continuous trading days etc. This new regulation can help investors irrespective of investment size when looking to exit.

Standardisation of tracking measures

Passive funds are supposed to efficiently track the underlying index. But for a variety of reasons, they don't do it as efficiently as they should. The gap between index performance and fund performance is measured in two ways. One, tracking error i.e. the annualised standard deviation of the difference in daily returns between the underlying index or goods and the NAV of the ETF/index fund. Two, tracking difference i.e. the annualised difference of daily returns between the index or goods and the NAV of the ETF/ index fund.

SEBI has now spelt out norms for tracking measurement so as to bring in standardisation. So, tracking error for passive funds (other than debt ETFs/ index funds) based on past one year rolling data shall not exceed 2%. Also, all ETFs/ index funds (including debt funds), have to disclose the tracking error based on past one year rolling data, on a daily basis, on the website of respective AMCs and AMFI. So far, AMCs were using 1 or 3 year rolling data and either daily rolled or monthly rolled for calculating tracking error and hence a uniform comparison was difficult. While no limit has been fixed for tracking difference for equity ETFs / index funds, for debt funds the annualised tracking difference averaged over one year period shall not exceed 1.25%.

One particular sub-segment of passive funds i.e. international ETFs has high tracking error, according to industry sources. Given the new market making norms and tracking error regulations, investors should watch out for possible migration of international ETFs to international index funds if the current norms hold, they say..

Go-ahead for passive ELSS

In the actively managed fund space, there are over 30 Equity Linked Saving Schemes (ELSS) qualify for tax saving investments under Sec 80C. The SEBI has now opened the doors for passive ELSS. One of the arguments against active ELSS is often that they charge high expense ratio (direct plan: 0.38 per cent to 1.80 per cent; regular plans: 1.6 per cent to 2.6 per cent). But alpha of actively managed ELSS category is unimpressive. Sample this: just 9 of 34 funds have beaten their benchmark in three-year period (which is a compulsory lock-in). This reinforces the case for passives. Mutual funds can launch either an active ELSS or a passive ELSS (through index fund route).

The proposed passive ELSS offering has to be based on one of the indices comprising of equity shares from top 250 companies in terms of market capitalisation. Given that most of the AMCs have active ELSS, it remains to be seen how many opt for passive ELSS ; the new crop of AMCs may take the lead in this aspect.

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