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SEBI Circular on the Development of Passive Funds

SEBI Circular on the Development of Passive Funds


Recently, an upsurge has been observed in investments made by global retail investors in passive funds such as Exchange Traded Funds (ETFs) and Index Funds as an investment product. The emergence of passive funds as an investment option is because of their numerous advantages such as diversification, transparency, lower costs in comparison to other active funds etc. Taking into account the acceptance of such funds from retail investors, the Securities and Exchange Board of India (SEBI) constituted a Working Group (WG) with representations from various stakeholders from the passive funds domain like Stock Brokers, Mutual Fund Trustees, AMCs, Stock Exchanges, Clearing Corporations, Market makers, industry experts etc. In furtherance of the recommendations of the WG, SEBI has released a circular titled “Development of Passive Funds”.    

Who Are The Entities To Whom The Circular On Development Of Passive Funds Is Applicable?

The circular on “Development of Passive Funds[1] is applicable to the following entities:

  1. All Clearing Corporations
  2. All Recognised Stock Exchanges
  3. All recognised Stock Exchanges 
  4. All Asset Management Companies (AMCs)
  5. All Mutual Funds
  6. All Custodians
  7. All Depositories
  8. All Trustee Companies/ Boards of Trustees of Mutual Funds
  9. All Registrar and Transfer Agents (RTAs)
  10. Stockbrokers cum Market Makers
  11. Association of Mutual Funds in India (AMFI)

Highlights of the Circular on Development of Passive Funds   

On 23rd May, SEBI came out with a circular titled “Circular on Development of Passive Funds”, covering a range of issues related to the Exchange Traded Funds (ETFs) and index funds. SEBI has stepped beyond and introduced a new category of mutual fund scheme called Passive ELSS (equity-linked savings scheme).

Passive ELSS

Though SEBI has allowed the Mutual Funds to launch passively managed ELSS, a restriction has also been imposed where a mutual fund can either run an actively managed ELSS scheme or a passively managed one. MFs have been restricted from launching ELSS in both categories.

The passive ELSS scheme has to be based on one of the indices comprising equity shares of the top two hundred and fifty companies in terms of their market capitalisation. It is believed that this step will allow the new fund houses to float a passively managed ELSS Fund, who are especially focussing on passive schemes.

Amidst the growing popularity of passive funds as an investment product among global retail investors, a framework has been put in place by SEBI in order to manage ETFs and Index Funds.

As part of the SEBI laid framework, guidelines have also been issued for debt ETFs and index funds, its constitution, market-making framework for ETFs, awareness charges, investor education, disclosure guidelines and other related provisions.

SEBI has mandated that the norms for the debt ETFs or Index Funds will be based on the indices comprising Government Securities, Treasury Bills and/ or State Development Loans (SDLs) or corporate debt securities or a combination of Government securities and corporate debt securities.

In case of an index fund having at least 80 per cent weight of corporate debt securities, a single issuer is not allowed to hold more than fifteen per cent weight in the index in respect of AAA securities, not more than 12.5 per cent in the AA rated securities and not more than 10 per cent in case of A and below rated securities.

In a hybrid index, which comprises of both corporate debt securities and government securities, having 80 per cent weight of corporate debt securities, a single issuer has not been allowed to have more than fifteen per cent weight in the index in respect of AAA rated securities. In case of AAA rated securities of both PSUs and PFI (Public Financial Institution) issuers, the limit has been set at 15 per cent.

Additionally, in the case of AA-rated securities, a single user has not been allowed more than 8 per cent weight in the index and the limit has been set at 6 per cent in case of A-rated securities.

Norms for market-making framework for ETFs

SEBI mandates that Asset Management Companies (AMCs) have to appoint at least two market Makers (MMs), who are the members of stock exchanges, for ETFs to provide continuous liquidity on the exchange platform. MMs need to transact with AMCs only in multiples of creation unit size.  

Approved policy for market-making in ETFs

SEBI requires the AMCs to have an approved policy regarding market making in ETFs on the lines of the framework for market-making provided by SEBI. AMCs have to facilitate the in-kind creation and redemption of units of ETFs, including debt ETFs by market makers.

Contribution to Investor Education and Awareness initiatives

For investor education and awareness initiatives, SEBI said the charges applicable from ETFs or index funds will be 1 bps of the daily net assets of the scheme.

SEBI also said that the Funds of Funds who are investing more than 80 per cent of their Net Asset Value in the domestic funds will not be required to set aside 2 bps of their daily NAV towards Investor education and awareness initiatives.

For enhancing the liquidity in units of ETFs on the stock exchange platform, direct investments with AMCs will be facilitated for only  those investors who are making transactions above a specified threshold limit.

Any order that is placed for subscription or redemption directly with the AMC should be greater than 25 crores and this threshold shall not be applicable for market makers and will be periodically reviewed.

The investors have been allowed to directly approach the AMC for redemption of units of ETFs for transactions above Rupees 25 crores without any exit load in certain cases.

According to SEBI, at the time of New Fund Offer (NFO) for debt ETFs or index funds and other ETFs or index funds, the minimum subscription amount shall be Rupees 10 crores and 5 crores respectively.

For the clarity and proper understanding of the investors, the nomenclature of the ETFs or index funds shall include the name of the underlying index or goods. In the case of ETFs, after listing of the units, the scrip code of such ETFs will be disclosed in the nomenclature at all places.

Date of Coming into Effect

The framework released by SEBI shall come into effect from 1st July, 2022 onwards and will be applicable to all the existing ETFs and Index Funds.

Read Our Article: Private Equity Funds – Its types and Advantages

Prabhat Nigam

Prabhat has done his BA LLB (Hons) and has been writing research papers since his law school days. His interest in content writing made him pursue a career in legal research and content writing. His core areas of interest are indirect taxes, finance and real estate.

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