DEVELOPING PASSIVE INVESTING
Market regulator SEBI brings in regulations to improve and open up the complex exchange traded funds (ETFs) and index funds as a viable option for investors
Market regulator SEBI came up with a host of regulations for passively managed funds with a circular in May. The circular is aimed at improving the liquidity, tracking error limits and disclosures for exchange traded funds (ETFs) and index funds. Passive investing could be through index mutual funds and ETFs, both of which track the performance of a given index. For example, you could have an index fund that tracks the S&P BSE Sensex and also an ETF.
What is the difference? Units of ETFs can be bought and sold on the stock exchanges, whereas the index fund functions like any other mutual fund with its NAV (net asset value) indicating its value. In the case of ETFs, you mandatorily need to have a demat account and need to invest a minimum of one unit, similar to buying or selling a regular share on a stock exchange through a recognised broker. Index funds are like other MFs in which you can buy units of the index it represents.
The circular proposes to help develop the passive investing space with the introduction of more debtoriented ETFs as well as a possible ELSS (equitylinked savings scheme) ETF which could attract firsttime investors who are otherwise wary of actively managed mutual funds. However, one of the pitfalls with ETFs is the limited market for it; they depend on the trades in them, which mean sometimes there may be no market for buyers as there are only sellers. The circular is an attempt to address this limitation of the ETFs and, at the same time, introduce changes that can standardise the ETF segment and also put a price band to the charges applicable with these funds.
An ETF unit is created through an authorised participant (AP) who may be a ‘market maker’ or a large financial institution. The AP goes into the market and buys the underlying securities the ETF has to hold and delivers those securities to the ETF issuer. In return, the issuer gives the AP a block of ETF shares that can be sold in the open market. For example, if an ETF is to track the S&P BSE Sensex, the AP buys all the 30 stocks in the index in identical weights.
The AP then delivers the 30 shares to the ETF provider; in return, the AP receives a ‘creation unit’—a block of equally valued ETF shares. The process works in reverse too at the time of sale of an ETF unit. In this way, ETFs gain access to the market and keep the ETF prices in line with its underlying holdings. And, as these trade like stock, the share prices fluctuate during the day. When they deviate from net asset value, APs rely on the creation or redemption mechanism to bring ETF share prices back in line with fair value.
To address this complexity, SEBI has allowed AMCs
GLOBALLY, PASSIVE INVESTING THROUGH ETFs HAS FOUND MORE TAKERS, AND IT IS PERHAPS TIME FOR INDIAN INVESTORS TO ALSO BENEFIT FROM THE SEGMENT
(asset management companies) to create or redeem units of ETFs without upfront payment of 100 per cent value of such units or upfront delivery of such units by the market makers. This will make the redemption process more liquid. Another aspect unique to ETFs is the tracking error. Tracking error is an indicator of the variability in the performance of an index fund and ETF, which indicates the consistency of the fund’s tracking difference during a specific time period. Tracking error gauges how much of the returns from the index fund or ETF have deviated from that of the benchmark index.
To make ETFs and index funds more investorfriendly, SEBI has introduced tracking error caps and better disclosures. For instance, in case of debt ETFs, the tracking error on an average over the past one year cannot be more than 1.25 per cent. In case of equity ETFs, the tracking error should not be more than 2 per cent on an annualised basis. Additionally, the tracking error for passive mutual funds needs to also disclose ‘tracking difference’ on a monthly basis. The difference between the index product’s return from that of its benchmark index as on a particular date is called tracking difference.
With these changes, the passive investing space opens up opportunities for AMCs looking to tap this investor space and for investors. Passive funds could become the goto investment option given their simplicity, model of tracking an index and also ease of trade in them. Globally, passive investing through ETFs has found more takers, and it is perhaps time for Indian investors to also benefit from the numerous ETF and index funds that exist and capitalise on the market indicators. ■