Why Radhika Gupta believes SEBI's new guidelines will spur passive fund innovation and growth

An enabling regulatory environment can be critical in empowering an industry and assisting it in long-term growth and success. The Securities and Exchange Board of India (SEBI) has published a number of laws that have given the passive fund industry a boost and might potentially accelerate its expansion.Passive schemes, such as exchange-traded funds (ETFs) and index funds, currently have Rs 5.27 trillion in assets under management (AUM). This equates to roughly 15% of the mutual fund industry's total assets under management (AUM), emphasising the potential that has yet to be realised.

SEBI is creating a passive fund ecosystem that supports key structural and macroeconomic reforms, with a focus on enhancing liquidity and protecting investors, through the circular titled 'Development of Passive Funds.' Let's take a closer look at the many ramifications and effects of the much-needed circular.

Fixed-income passives are on the rise

Investors currently prefer ETFs, and a month-over-month review of index fund data shows that debt accounts for a significant portion of the volume. As a result, debt is a rapidly growing asset class, with the debt ETF and index fund market now exceeding Rs 80,000 crore in volume. SEBI's circular, which tightens restrictions on asset management firms (AMCs) while also increasing investor demand and overall liquidity, is a crucial and critical enabler for the category as a massive business with immense underlying potential. The first section of the circular divides debt ETFs into three categories: ETFs that trade only corporate bonds, index funds that trade only government securities, and a hybrid ETF category that trades both corporate debt and G-Secs. The classification is intended to establish clear boundaries for each of the groups.

Second, the circular explains new debt ETF and index fund rules, stating that SEBI has required graded single-issuer restrictions based on credit rating, such as 15% for AAA-rated papers. This change is expected to require debt index funds to have group-level exposure restrictions, as well as distinct replication criteria for the three categories of debt passive funds.

ETF liquidity is expected to improve

For investors weighing their alternatives, asset class liquidity is an important statistic to consider. High-liquidity assets are easy to sell, making them preferable to assets that may lock up investors' capital for a longer period of time. The circular ordered procedures to increase ETF liquidity in an attempt to pique investor interest while also enhancing the market's overall potential. As a result, AMCs will be required to select at least two market makers in order to assure ongoing liquidity, as well as create incentive plans for these organisations. The circular also encourages market maker participation by introducing a new market making settling mechanism that balances inflows and so improves liquidity.

Furthermore, AMCs can now create units immediately for transactions worth more than Rs 25 crore. As a result, some transactions will be forced onto exchanges, increasing both demand and supply and providing a powerful structural play for expanded investor engagement and exchange liquidity.

Keep an eye out for tracking errors

The circular aims to facilitate a comprehensive investor journey, with one of the important aspects being the reduction of tracking differences and the resulting tracking error. Simply put, tracking difference refers to the difference in performance between an ETF and its underlying benchmark index, whereas tracking errors refers to the consistency of the ETF's tracking difference over time.

SEBI has advised equities passive funds to keep tracking error to a maximum of 2%, with the statistic derived using rolling data from the previous year. As a result, the tracking error must be revealed every day on a one-year rolling basis. Investors will be able to track the effectiveness of their passive fund investments using tracking error limitations. Furthermore, the tracking difference for debt passive funds should be less than 1.25 percent on an annualised basis. All index exposures authorised under replication norms will be tracked by this mandate.

Creating an environment conducive to innovation

Given the growing demand for passive funds, there is a lot of room for innovation in the sector, and the SEBI circular represents the first move in that direction. From the investor's perspective, making fresh and innovative passive funds available for investment is critical. SEBI has decreased the minimum subscription amount for new debt and equity passive funds to Rs 10 crore and Rs 5 crore, respectively, through the circular, with AMCs authorised to contribute the initial fund required for unit creation. The move is intended to make the process of founding passive funds more straightforward.

AMCs can now now start passive equity-linked saving schemes (ELSS) based on indexes of the top 250 equities, as long as they only provide one ELSS fund, active or passive.

A careful examination of the circular reveals a slew of positive indicators for the passive fund market across a number of key criteria. Furthermore, with SEBI's sustained focus on the sector, there is now unrivalled potential for both long-term growth and significant development.