*****Passive approach | Business Standard Editorials

Clipped from: https://www.business-standard.com/article/opinion/passive-approach-122052501667_1.html

Sebi’s plans will offer more options to investors

In a recent circular, the Securities and Exchange Board of India (Sebi) issued an important update that is a potential game changer for passively managed funds. Equity-linked saving schemes (ELSS) can now offer passive options. This should lead to more efficient tax-saving options for retail investors. In addition, the regulator has outlined possible structures for passive debt funds and offered suggestions which would enhance the liquidity of exchange-traded funds (ETFs). Sebi suggests passive ELSS funds should track the 250 largest companies in terms of market capitalisation, and lays down limits for tracking error (average difference in daily returns) and tracking difference (difference in annual returns). Tracking errors and differences should be published on a daily basis.

The circular, however, restricts asset management companies (AMCs) to run either passive or actively-managed ELSS, not both. Efficient market theory postulates that it is difficult to beat the market return consistently. Indeed, passive funds do beat the vast majority of actively-managed funds in most large markets. One key difference between an ELSS and a standard mutual fund scheme is that the ELSS has a minimum lock in period of three years. This makes it easier for the fund manager to invest because of the lack of redemption pressure. A passively managed scheme does not attempt to beat the market; instead it picks stocks by mirroring the weightage of the said stocks in a benchmark index. Hence, the return should be close to the return from the given index. The difference between an ETF and an index fund is that the units of an ETF are listed and traded on stock exchanges.

In another progressive move, the regulator has laid down criteria for passive debt funds, which may be tracked via constructing an underlying index of debt instruments. Passive debt is a new concept for most investors. The constructed debt index cannot have more than 25 per cent exposure to the debt of the same business group. Similarly, the index cannot have more than 25 per cent weight in the same sector. If the constructed index has 80 per cent exposure to corporate debt securities, there would be limits of 15 per cent exposure to a single AAA-rated security, and 12.5 per cent exposure to AA-rated securities, while A-rated securities will have a limit of 10 per cent. There are no limits on government securities. This limitation of exposure to single companies and groups reduces exposure to possible fraud, or collusion between a group and a fund.

In the case of ETFs, the regulator has prescribed that only transactions above Rs 25 crore can be done directly with the AMC. Every fund must appoint at least two market makers, who are members of the stock exchanges and their compensation should be considered part of the total expense ratios with a transparent incentive structure. This will induce a greater volume of ETF trading on exchanges and reduce the difference between daily ETF price and the net asset value. The charges for investor awareness will be reduced to 1 basis point from 2 basis points for such funds, and the charges will be waived for fund of funds with over 80 per cent of corpus invested in such instruments. Taken together, these measures should lead to more options for retail investors and further the development of passive instruments.

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