The Securities and Exchange Board of India (SEBI) recently issued a circular on passive funds covering matters related to transparency, liquidity and operational aspects of exchange-traded funds (ETFs) and index funds.

What are Passive Funds?

• A passive fund is an investment vehicle that tracks a market index, or a specific market segment, to determine what to invest in.
• Unlike with an active fund, the fund manager does not decide what securities the fund takes on.
• This normally makes passive funds cheaper to invest in than active funds, which require the fund manager to spend time researching and analysing opportunities to invest in.
• Tracker funds, such as ETFs (exchange traded funds) and index funds fall under the banner of passive funds.

What is a passive ELSS scheme?

• Passive funds mimic an underlying index. By contrast active funds are actively managed by fund managers.
• The SEBI has now introduced a passive equity-linked saving schemes (ELSS) category, which will give taxpayers another investment option to avail of tax benefits.
• According to the circular, the passive ELSS scheme will be based on any index comprising equity shares from the top 250 companies in terms of market capitalization.
• Beginning 1 July, a fund house will be able to either have an active ELSS scheme or a passive ELSS scheme, but not both.

What are the norms for debt ETFs?

• Passive debt funds are now divided into three categories:

1. Corporate debt funds with exposure to corporate bonds
2. G-Sec funds investing in government securities, and
3. Hybrid funds where allocation is a combination of corporate bonds and government securities

• Currently, debt funds in the passive category invest only in AAA-rated instruments.
• The Sebi circular introduces norms for each debt fund category, including portfolio exposure limits to each sector, the issuer (based on rating) and group.
• Application of these provisions should help mitigate concentration risk in debt ETFs/ index funds.

What about tracking error?

• As per Sebi’s circular, passive funds must disclose ‘tracking error’ and ‘tracking difference’ in their monthly fact sheets.
• These metrics indicate how different the performance of the fund is compared to its underlying index—an effort to keep investors better informed.
• The circular specifies limits for tracking error and tracking difference, which passive funds must follow.

What is the mandate on disclosing NAVs?

• Because of poor liquidity for ETFs in the secondary market in India, ETF prices could differ widely from the net asset value (NAV) of the fund.
• The NAV of the fund represents the value of the underlying asset of the ETF.
• The Sebi circular mandates disclosure of NAV (indicative) on a continuous basis throughout the day on the stock exchange.
• While the practice is already in existence, Sebi rules institutionalize it.
• Checking the NAV can help one avoid making a transaction at a significant premium or discount.

Can one execute ETF transactions directly?

• Investors can buy or sell units of ETFs only on stock exchanges.
• But, large buy or sell transactions can also be directly placed with the fund house.
• Sebi now says orders greater than ₹25 crore alone can be placed for redemption or subscription directly with the asset management company (AMC).

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