On July 1, Sebi’s new rules for ETFs and passive funds come into effect. Having been in existence for a few decades, and with significant sums now committed to the passive ETF space by the largest pension fund EPFO (also the largest single fund in the country), Sebi has formed a task force made up of representatives from industry to see how these might smooth the functioning of the ETF market.
As a starting point for broader reform, the Circular addresses the concerns of issuers, authorized participants, market makers and investors while helping everyone stay abreast of market developments.
The most significant changes are in the bond markets (with the exception of Bharat Bond – largely the idea has been to leave existing large pools unaffected).
Corporate bonds are languishing and ETFs are seen as a way for investors to participate in the market and earn the attractive returns currently available without taking cash and risking money with single issuers. Managers have leeway by ensuring that at least 60% of index securities must represent 80% of the net asset value and that non-index securities must not exceed 20% while at least 8 issuers must be included in the underlying index.
This separate set of rules for fixed income will go a long way to inducing liquidity in bond markets by trading baskets and securing ETF trades in the event of liquidity issues, such as a few fund closures we’ve seen. in the recent past.
This larger pool of issuers contributes to the liquidity of ETFs in adverse market conditions.
Similarly, unique names (issuers) in the ETF/passive portfolio are restricted to AAA: maximum 15%, AA: maximum 12.5% and A&lower: maximum 10%, which is very useful for risk control with these limits on the riskiest securities.
A diverse pool of issuers balances investor rewards with the security allowing indexers and fund managers to create laddered bond portfolios.
One of the other issues addressed is exposure aggregation. Often we see group entities lending to each other, leaving investors exposed to sectors like real estate or infrastructure when they may have only wanted media exposure.
To this end, group-wide limits are imposed which cannot exceed 25% and with single sectors capped at 25% of NAV.
With this in place, a passive hybrid debt fund (and ETF) class is possible where 80% of securities must be corporate bonds with single issuers capped at Corp AAA: max 10% and G-Sec/PSU AAA : maximum 15%. With these, a fund or ETF can have bonds rated AA up to a maximum of 8% and A& below
For equities, the new fund is a passive ELSS. However, the fund house can only have one option – passive or active ELSS. As these are long-term investments, this will give investors the opportunity to compare passive versus active management over longer periods of time.
In the passive space, iNAVs should be available on the exchange, tracking error and tracking difference should also be published and freely available, allowing investors and advisors to access critical information that was not readily available in the past.
One of the complications of the Indian ETF market has been trading liquidity. In a first step to address this and increase volumes on the exchange, the regulator has now mandated a direct transaction limit with AMC of Rs 25 crores (albeit with some caveats) unless one is an authorized attendee, in which case, they may downgrade tickets.
This is by no means the end of regulatory inputs. Although, we may see some nuanced market developments come with appropriate regulation in the future. With the current changes, we are sure to see renewed interest in the product directly and in the underlying strategies. Investors will directly benefit from finer pricing, reduced tracking errors, better information flow as well as a wider basket of products available.