How SEBI’s new rules can drive innovation and growth of passive funds

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An enabling regulatory environment can be instrumental in empowering an industry and helping it both grow and thrive over the long term. The recent slew of regulations announced by the Securities and Exchange Board of India (SEBI) have given the passive fund industry a shot in the arm and will potentially accelerate its growth. Currently, passive schemes, including exchange-traded funds (ETFs) and index funds, have assets under management (AUM) of Rs 5.27 trillion. This translates to approximately 15 percent of the total AUM of the mutual fund industry, clearly underscoring the potential that remains to be explored.

Through the circular titled ‘Development of Passive Funds’, SEBI is fostering a passive fund ecosystem that facilitates essential structural and macroeconomic changes, with a focus on promoting liquidity and protecting investors. Let us take a deep dive into the varied implications and the impact of the much-needed circular.

Fixed-income passives poised to grow big

Investors today are very partial to ETFs and a month-on-month analysis of the index fund data indicates that a substantial part of the volume is driven by debt. Debt is, therefore, a fast growing asset class, with the debt ETF and index fund market already commanding a volume of Rs 80,000 crore. As a huge industry with tremendous underlying potential, SEBI’s circular is a timely and essential enabler for the segment as it places tighter regulations on asset management companies (AMCs) while also enhancing investor appetite and overall liquidity. At a macro level, the first part of the circular breaks debt ETFs into three different categories—ETFs that trade purely corporate bonds, index funds engaged in government security trades and, finally, a hybrid ETF category that combines both corporate debt and G-Secs. The classification is aimed at creating distinct limits for each of the categories.

Secondly, the circular has elaborated on new norms for debt ETFs and index funds whereby SEBI has mandated graded single-issuer limits based on credit rating, such as 15 percent for AAA-rated papers. This move is expected to mandate group-level exposure limits for debt index funds, in addition to bringing forth separate replication norms for the three types of debt passive funds.

Liquidity in ETFs to improve

Liquidity of an asset class is an important metric for investors considering their options. Assets boasting high liquidity are easier to sell, making it more preferable to assets that may tie down investors’ funds for a longer duration. The circular has mandated provisions to boost liquidity in ETFs in an attempt to whet investor appetite while also bolstering the overall potential of the market. Accordingly, AMCs will have to appoint at least two market makers to ensure continuous liquidity, in addition to framing incentive plans for such entities. The circular is also encouraging market maker participation through a new market making settlement process that nets off the inflows, thus enhancing liquidity.

Further, AMCs can now directly create units for transactions only above Rs 25 crore. Several transactions will, therefore, be pushed onto the exchanges, raising both demand and supply, creating a potent structural play for increased investor participation and higher liquidity in exchanges.

Eye on tracking error

The circular is aimed at facilitating a holistic investor journey and one of the key points here is minimising tracking difference and the resultant tracking error. Put simply, tracking difference indicates the difference in performance between the ETF and the underlying benchmark index while tracking errors refers to the consistency of the ETF’s tracking difference during a fixed period of time. A higher tracking error actually defeats the purpose of investing in ETFs as it leads to a difference between the returns on the passive fund and its underlying index.

In the circular, SEBI has prompted equity passive funds to limit tracking error to 2 percent, with the metric being calculated based on the rolling data for the last year. Accordingly, the tracking error is to be disclosed on a one-year rolling basis every day. Tracking error limits will act as an effective way for investors to track the efficiency of their passive fund investments. Further, the tracking difference for debt passive funds should be below 1.25 percent, averaged over the last one-year period. This mandate will track all index exposures allowed under replication norms.

Enabling innovation

Considering the strong appetite for passive funds, there is tremendous scope for innovation in the sector and the SEBI circular can be taken as the first step towards enabling this. Making new and innovative passive funds available for investing is an important aspect here, from the investor’s point of view. Through the circular, SEBI has reduced the minimum subscription amount for new fund offers in debt and equity passive funds to Rs 10 crore and Rs 5 crore, respectively, with AMCs being allowed to contribute the initial fund required for unit creation. The move is aimed at easing the process of launching passive funds. Further, AMCs can now launch passive equity-linked saving schemes (ELSS) based on indexes comprising the top 250 stocks, as long as they offer only 1 ELSS fund, either active or passive.

A thorough analysis of the circular indicates a host of positive measures for the passive fund segment, across important variables. Further, with SEBI’s continued focus on the segment, there is now unparalleled scope for both sustainable growth and impactful development.

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