SEBIs guidelines for passive funds are good but the regulator should facilitate more India-specific indices
Passive funds, which simply mirror an index or asset without active fund manager calls, have lately become the main route through which global investors participate in financial markets. Low fees, negligible manager risks and ease of choice are key advantages of passive investing over the active route. But in India, passive funds account for just 14 per cent of mutual fund assets. Lack of active promotion by funds and intermediaries, high tracking errors and mispricing and liquidity issues when transacting in ETFs (Exchange Traded Funds), are key reasons for the limited investor interest. SEBI’s latest circular on the development of passive funds aims to tackle these issues, while laying down ground rules for the passive debt category.
One of the key challenges facing Indian ETF investors is their lack of secondary market liquidity which also leads to market prices straying widely off NAVs. To address this, SEBI has asked AMCs to appoint at least two market makers for each ETF who will exchange baskets of stocks for units and vice versa, with the AMC. While market-making is supposed to bridge bid-ask spreads, it is a capital-intensive business and has yielded mixed results with other assets in the past. SEBI allowing larger ETF investors with a ₹25 crore threshold, to directly transact with AMCs can help institutions such as the EPFO invest more efficiently in passives. For retail investors, SEBI has also asked AMCs to open a liquidity window for transactions below ₹25 crore, if ETF units are heavily discounted or thinly traded. But some of these rules are onerous and may nudge AMCs to launch more open-end index funds instead of ETFs in future. SEBI’s move requiring all ETFs/index funds to disclose their tracking error and tracking difference daily should promote better management, though the ceiling of 2 per cent on tracking error and 1.25 per cent on tracking difference appears a little too liberal. On the debt side, where passive funds only loosely mirror benchmarks owing to market imperfections, SEBI has tried to reduce the elbow-room for funds to stray while setting limits on risk-taking. Passive debt funds tracking corporate bond indices will now need to ensure at least 80 cent index replication and stick to a 15 per cent single-issuer limit. Target maturity funds cannot allow their portfolios to deviate from the index by more than 10 per cent. While these rules are welcome, the current crop of passive debt funds are still complex, as they track custom-made indices that combine PSU bonds, G-secs and State Development Loans. Simpler debt funds that offer pure-play exposure to say, A1 plus commercial paper or 3-year gilts would be welcome.
Passive products can only be as good as the indices they track. On this score Indian markets have limited variety to offer, with only the arms of the two stock exchanges offering indices. SEBI should get more global index providers to launch India-specific indices based on factor and smart-beta investing. In the long run, both the fund industry and retirees would benefit, if pension funds such as the NPS and EPF can be encouraged to take only the index route to investing in both the debt and equity markets.
Published on May 25, 2022