Moneycontrol PRO
Upcoming Webinar:Watch a panel of experts discuss: Challenges of continuously evolving regulation for Cryptocurrency, on 7th July at 3pm. Register Now

How Sebi guidelines on ETFs and index funds will impact investors

Market regulator wants to improve liquidity for exchange traded funds (ETFs) and make passive funds more efficient in tracking underlying indices

May 25, 2022 / 08:26 PM IST

The Securities and Exchange Board of India (Sebi) has come up with a host of regulations for passively managed funds, with most of them aimed at improving the liquidity, tracking error limits and improving disclosures for exchange traded funds (ETFs) and index funds.

Let's take a look at the regulatory changes and their impact on investors.

Direct transactions with mutual funds

Sebi has stipulated that only transactions that are above Rs 25 crore of value, can be done directly with the asset management companies (AMCs).

The industry practice was that the investor could create or redeem units directly with the AMC, if the units held were in the creation unit size.


For example, ICICI Nifty 50 ETF’s creation unit size is 50,000 units, which amounts to around Rs 86 lakh at current NAV. So, an investor could transact directly with the AMC for Rs 86 lakh and above.

This led to lower liquidity on the exchanges for ETFs as large transactions happened directly with AMC.

Setting a threshold would ensure that more ETF transactions take place on the exchanges. Higher liquidity on exchanges can help to reduce the impact costs when trading on ETFs.

However, the Rs 25-crore threshold will not apply if there are any tracking errors or liquidity issues. “Traded price (closing price) of the ETF units is at discount of more than one percent to the day-end NAV for seven continuous trading days, or no quotes for such ETFs are available on stock exchanges for three consecutive trading days,” the Sebi circular said.

Market making

The markets watchdog also wants AMCs to make sure that there are at least two market makers appointed.

The job of market makers is to again ensure that there's enough liquidity on the exchanges for ETFs by simultaneously providing buy and sell quotes.

If any incentives are to be paid to the market makers, they will be charged as part of the maximum total expense ratio (TER) allowed on the scheme.

To make the market-making less capital intensive when it comes to equity ETFs, Sebi has allowed AMCs to create or redeem units of ETFs “without upfront payment of 100 percent value of such units or upfront delivery of such units by the market markets”.

Siddharth Srivastava, Head of ETF Products at Mirae Asset Global Investments, said this will reduce the cash requirement for market makers significantly. “Only cash that will be required would be for difference of ETF units and the underlying stocks, the cash component of ETFs, and the stamp duty that the market maker is liable to pay,” he said.

However, Deepak Shenoy, founder and chief executive officer at Capitalmind, says that only allowing members of stock exchanges to work as market makers is restrictive and may not be enough to provide liquidity for ETFs.

Tracking error caps and better disclosures

Sebi has stipulated the maximum range of tracking errors that passive funds can work within.

For debt ETFs, the tracking error on an average over last one year cannot be more than 1.25 percent.

For equity ETFs, the tracking error should not be more than two percent on an annualised basis.

Industry executives say more clarity would be needed for international ETFs that are managed domestically. "When it comes to such international ETFs, there are different time-zones, different market opening and closing times, that will impact timing of aligning the ETF with that of the index," said an MF official, requesting anonymity.

Any breaches from this range will have to be brought to the notice of the trustees and corrective action will need to be taken by the AMC.

Sebi has further stipulated caps for target maturity funds to make sure that the fund is closely aligned to residual maturity of the underlying index.

Also, to make sure investors are better informed about the tracking efficiency of the passive fund before investing, Sebi wants all passive funds to disclose the tracking error based on past one-year rolling data, on rolling basis, on their respective websites and Amfi.

Earlier, AMCs had to disclose tracking error using last three years’ data in the monthly factsheets.

Re-balancing in passive funds

If there is a change in any index constituent due to periodic review, the portfolio of ETF and index fund can be re-balanced within seven working days.

However, debt passive funds will get more time if the index constituent is being changed because of a rating downgrade.

If there is a rating downgrade and the security falls below the rating criteria of the index (including downgrade below investment grade), the passive funds – ETF or Index Fund – will get 30 days to change its portfolio accordingly.

Experts say this is a welcome move as earlier debt passive funds would just get five days to make changes in the portfolio when there is a rating downgrade.

A stressed sale of a debt security in the market can negatively impact the NAV of the scheme.

NFOs and Passive ELSS

Sebi has made it easier for new fund launches of passive funds. The minimum subscription requirement for NFOs has been reduce to Rs 10 crore for debt ETFs and index funds, and Rs 5 crore for equity ETFs and index funds.

Alternatively, the fund house need not even launch an NFO for subscription. Now, the fund house can also contribution the initial fund required for unit creation and then transfer it gradually to investors and market makers.

Sebi  has allowed AMCs to launch passively-managed equity linked savings schemes (ELSS). So, now investors will have one more product category that they can opt for, for their tax-saving investments.

The regulator wants such a scheme to be based on an index comprising of top 250 companies in terms of market capitalisation.

Only an AMC, which doesn’t have an already actively-managed ELSS, can launch a passively-managed scheme. So, some of the technology-centric new fund houses focusing only on passive funds, may look at this new product category.
Jash Kriplani is a journalist with over ten years of experience. Based in Mumbai. Covering mutual funds, personal finance. His last stint was with Business Standard, where he covered mutual funds and other developments in the financial markets
first published: May 25, 2022 01:49 pm
ISO 27001 - BSI Assurance Mark