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Decoded: New regulatory changes around the Passive funds

Over the last two to three years, passive funds across equity and debt have gained popularity. The Securities and Exchange Board of India (SEBI) proposed amendments to passive funds (ETFs) rules to promote exchange-traded funds. This article will decode the new regulatory changes around passive funds.
Future of passive funds

The rise of passive funds

In the last few years, investments in passive funds such as index funds and Exchange Traded Funds (ETFs) have significantly risen. In March 2017, the passive industry assets under management (AUM) were Rs. 52,386 crores. In five years, the AUM has grown to Rs. 4,99,319 crores (as of March 2022), which shows a growth rate of 57% CAGR. AMCs have introduced a lot of passive schemes. Investors have also adopted them wholeheartedly. SEBI has issued new regulations to encourage participation in passive schemes and standardise investment, management, and redemption procedures. 

SEBI circular on the further development of passive funds

On 23rd May 2022, SEBI issued a circular for further development of passive funds. The salient features of this circular include:

  1. Norms for debt Exchange Traded Funds
    • SEBI has mentioned that debt ETFs or index funds can be based on indices comprising of:
      1. Corporate debt indices comprise corporate debt securities.
      2. G-sec indices comprise Government securities (G-secs), treasury bills (T-bills), state development loans (SDLs), etc.
      3. Hybrid debt indices comprise corporate debt securities, G-secs, T-bills, SDLs, etc.
    • For passive debt funds, the AMC shall ensure the rating of the index constituents shall be investment-grade and above. In addition, the constituents shall be reviewed periodically. The passive fund portfolio must be rebalanced whenever the index is rebalanced within seven calendar days.
  2. Norms for the market-making framework for ETFs
    • The AMC shall appoint at least two market makers (MMs) for ETFs to provide continuous liquidity on the stock exchange platform.
  3. Investor education and awareness
    • SEBI has directed AMCs and AMFI to carry out focused investor education and awareness initiatives for passive funds. ETFs and index funds will have to set aside one bps (basis points) of daily net assets of the scheme for investor education and awareness initiatives. A hundred basis points are 1%; hence, one basis point will be 0.01%. The education and awareness initiatives will help in broader and deeper penetration of the concept of passive funds among the masses.
  4. Tracking error
    • The tracking error is the annualised standard deviation of the difference in daily returns between the underlying index and the NAV of the passive fund based on past one-year rolling data. SEBI has mentioned that the tracking error should not exceed 2%.
    • For example, ABC Nifty 50 Index Fund has the Nifty 50 Index as the underlying index. As per SEBI guidelines, the tracking error between the Nifty 50 Index and the ABC Nifty 50 Index Fund should not exceed 2%.
    • Under any circumstances, if the tracking error exceeds 2%, it should be brought to the notice of the Trustees with corrective actions taken by the AMC, if any. In addition, all passive funds must disclose the tracking error based on the past one-year rolling data daily on the respective AMC and AMFI website.
    • The daily publishing of the tracking error will help investors compare the performance of the passive fund with the underlying index and review its performance.
  5. Disclosure of indicative Net Asset Value (iNAV)
    • The indicative Net Asset Value (iNAV) of an ETF is the per unit NAV based on the current market value of the ETF portfolio during the stock market trading hours. SEBI has said AMCs must disclose the ETF iNAV continuously on the stock exchange(s) where the ETF units are listed and traded. In addition, the iNAV for equity ETFs has to be updated within a maximum time lag of 15 seconds from the underlying market. 
    • The iNAV continuous disclosure regulation will help ETF investors to track the ETF unit NAV and the unit trading price on the stock exchange. When purchasing the ETF units, the investor will be able to purchase them closer to the iNAV.
  6. Equity-linked savings scheme (ELSS) in the passive fund category
    • Earlier, AMCs could launch and operate active equity linked savings scheme (ELSS) under the “Equity Schemes” category only. But, as per the new regulations, AMCs will have the option to launch a passive ELSS through an index fund under the “Other Schemes” category. However, the AMC can have only one ELSS scheme in the active or passive category.
    • New AMCs will have an option to launch an ELSS scheme either in the active or passive category. The passive ELSS scheme shall be based on one of the indices comprising equity shares from the top 250 companies in market capitalisation.

New regulations will help in more profound and broader penetration of passive funds.

SEBI’s new regulations will be applicable from 1st July 2022. The regulations will apply to all existing ETFs and index funds. We may soon see new passive funds in the debt category based on debt indices. The market-making (MM) framework will help boost liquidity for ETFs. The education and awareness initiatives will help broader and deeper penetration of passive funds among the masses. The tracking error regulation will ensure it is maintained within 2%. The continuous publishing of the iNAV will help investors buy ETF units closer to the iNAV. And lastly, we may soon see an ELSS in the passive fund category.

Investing in mutual funds with the Glide Invest App

In this blog, we have understood the new regulations issued by SEBI for passive funds. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals

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To start investing towards your financial goals, download the Glide Invest App from Google Play Store or Apple App Store and get started.

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