SEBI allows mutual funds to launch passively-managed ELSS schemes

Further, SEBI laid down guidelines on how debt passive funds – exchange traded funds (ETFs) and index funds – should be managed.

These guidelines would ensure that the passive fund replicates a diversified underlying index.

Where the index has 80 percent exposure to corporate debt securities, the single issuer limit on AAA-rated securities was set at 15 percent.

For AA-rated securities, the limit was set at 12.5 percent. Single A-rated securities cannot constitute more than 10 percent weight in an index.

If the index is a hybrid index, i.e. one that comprises both corporate debt securities and G-sec or State Development Loans (SDLs), with up to 80 percent weight of corporate debt, the limits will be different.

A single issuer’s AAA-rated security cannot be more than 10 percent of the index. However, when it comes to AAA-rated securities of PSUs and public financial institutions, the single issuer limit is 15 percent.

A single issuer AA-rate security cannot be more than 8 percent, while single A-rated security cannot be more than 6 percent.

The index cannot have more than 25 percent exposure to the debt securities of the same business group. Similarly, the index cannot have more than 25 percent weight in the same sector.

For an index based on G-Sec and SDLs, single issuer limit will not be
applicable

Market making and liquidity enhancement

SEBI has prescribed that only transactions that are above Rs 25 crore can be done directly with the asset management company (AMC), where the investor place an order for creation or redemption of ETFs units with the AMC.

Niranjan Avasthi, Head Product Marketing and Digital Business, Edelweiss MF, said, "This move will help increase liquidity for ETFs on the exchanges and more investors will trade on exchanges, rather than directly trade with the asset management company."

To ensure liquidity of the ETFs on the stock exchanges, the mutual funds would be required to appoint at least two market makers, who are members of the stock exchanges.

If there any incentives to be given to the market makers, it should be charged to the scheme within the stipulated limit of total expense ratios (TERs).

SEBI wants mutual funds to have a transparent incentive structure in place for market makers.

These incentives will be linked to the performance of market markets in terms of generating liquidity for the ETFs.

Lower investor awareness charges

The charges applicable for investor education and awareness initiatives on
ETFs and Index funds have been slashed to 1 basis points from two basis points.

Meanwhile, fund of funds (FoFs) investing more than 80 percent of their NAV in underlying domestic passive funds, will not be required to set aside funds for investor awareness.

Easier NFOs for Debt ETFs and Debt Index Funds

To make new fund launches for debt exchange traded funds (ETFs) and Index Funds easier, the minimum subscription amount in such a new fund offer (NFO) has been reduced from Rs 10 crore to Rs 5 crore.

The fund house can also contribute the initial fund for unit creation. Later on, the fund house can transfer such units to market makers or other investors. 

Tracking the index

Apart from other guidelines, SEBI also re-iterated the tracking deviation that a passively-managed fund can have vis-à-vis the underlying index, which it is supposed to track.

The duration of the portfolio of Debt ETF and the Debt Index Fund has required replication of the duration of the underlying index within a maximum permissible deviation of +/- 10 percent.

In the case of target maturity Debt ETFs and Debt Index funds with a residual maturity of more than five years, the duration can deviate +/- 6 months or ten percent, whichever is higher.

For a target maturity Debt ETFs and Debt Index fund with a residual maturity of less than five years, the duration can deviate +/- 3 months or ten percent, whichever is higher.

A debt ETF and Debt Index Fund, while it is supposed to mimic the underlying index in terms of rating of underlying securities, upto ten percent deviation can be made in favour of higher-rated securities.

For debt ETFs, the tracking error on an average over the 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.

Re-balancing the fund

If the index constituents change due to periodic review, the portfolio of debt ETFs and Debt Index funds should be re-balanced within seven calendar days. In case the rating of any security is downgraded to below the rating criteria of the index (including downgrade to below investment grade), the portfolio should be rebalanced within 30 days.

If the rating of any debt security is downgraded to below investment grade, the said security may be segregated, i.e. a side-pocket will have to be carved out of the main portfolio to hold the security until its recovery.