On 1st July 2024, SEBI released a consultation paper for “Introduction of Mutual Funds Lite Regulations (MF LITE) for passively managed Mutual Funds Schemes.” aimed to “reduce the compliance requirement, foster innovation, encourage competition and promote ease of entry for the MFs interested in launching only passive schemes”.
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It would be to state the obvious to say that passive products – Index Funds and ETFs( Exchange Traded Funds) – have gained a lot of traction among Indian investors. There are 400 and counting products available in India. While most are equity products, there are some notable debt funds and, hopefully soon, hybrid funds.
In this article, the term passive fund refers to both index funds and ETFs, unless otherwise mentioned.
Passive funds have not been that low cost in India
With some notable exceptions like Bharat Bond products, the expense ratios of passive fund have been more than 10 basis points. Some ETFs have published lower expense ratios. For the investor, the meaningful metric is the Tracking Difference – the actual difference between the returns from the passive fund and the returns from the index during the period. Index returns are academic and on paper alone; investor returns are from the fund.
AMFI has a mandate to publish tracking difference (and the more technical tracking error) on a monthly basis. An analysis of the data for equity passives throws up some interesting observations:
- Some ETFs do have tracking differences lower than 0.1 (10 basis points) – Logistical problems with ETFs – price – iNav mismatch, market maker presence, etc. – require an article by itself
- Within the same fund house, the tracking difference increases as you go from Nifty 50 to other spaces, and from smaller to larger indices – 1 year tracking difference for some HDFC index funds:
- Nifty 50 fund – .29
- Nifty 100 – .46
- Nifty Midcap 150 – 1.37
- The older index funds show a declining trend in tracking difference – suggesting that they have managed some efficiency
Informally, fund house sources say that it is difficult to run an index fund in India at a cost lower than 0.2 per cent owing to the multiplicity of costs – transaction costs, brokerages, and also AMC costs.
MF Lite Proposal from SEBI
On 1 July 2024, SEBI released a Consultation Paper (CP) on Mutual Funds Lite Regulations. (MF Lite is SEBI’s own terminology.) The first statement in the document clearly mentions ‘relaxed regulatory framework … for passively managed MF schemes.” It goes on to say this: “Considering the lesser risk inherent in managing passively managed MF schemes, the proposed MF Lite Regulations intend to reduce the compliance requirement, foster innovation, encourage competition and promote ease of entry for the MFs interested in launching only passive schemes.” It is difficult to not agree with this! As an investor who has shifted to passive equity funds (with a notable exception) in the last decade, I am thrilled and excited by the idea itself and said as much in my comment on the CP.
The CP is available at: https://www.sebi.gov.in/reports-and-statistics/reports/jul-2024/consultation-paper-for-introduction-of-mutual-funds-lite-regulations-mf-lite-for-passively-managed-mutual-funds-schemes_84498.html
The highlights of the CP are:
- Lower networth requirements, easier structure etc. for sponsors of AMCs with only passive schemes
- Flexibility of current AMCs to move out existing schemes to a separate entity that meets MF Lite requirements
- Easier operating procedures and requirements for all passive funds – regardless of the structure
- Framework for hybrid passive funds
Some of the proposals are (necessarily) technical relating to the Sponsor-AMC-Trustee structure. The article would look to present them in a simplistic manner.
Process for giving suggestions on the CP
With the presumption that the readers would like to comment on the proposal, I would talk about the commenting process before going into the contents of the proposals. Last date: July 22nd 2024. Suggestions can be given here: https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes
The top half of the screen requires your personal details. I am unsure if they accept anonymous comments. ‘Investor’ is indeed a valid choice for Organization Type. You can then choose the CP that you want to comment on and the Regulations. Now comes the tricky part. The CP has 23 proposals. For each proposal you have these options:
- Skip to comment on the proposal (or)
- Choose to give your level of agreement – from Strongly agree or Strongly disagree
- Optionally choose to provide descriptive comments and rationale
One needs to make the choices for at least a few proposals before the Submit is successful. You can suitably navigate through your choices. The screen also has a button to view your comments so far, and also to download them all as a PDF file.
Detailed instructions are provided in page 32 of the CP.
CP Proposals on Schemes, Reporting, etc.
We would look at these first as they are simpler to understand. These are in Section II of the CP. They would cover schemes launched by the MF Lite AMCs as well as current passive funds. (Author’s wish: Even if MF Lite does not take shape, these proposals should at least go ahead.)
- CP 13 – Investor Education – Smaller passive funds need not set aside any part of the TER for investor education fund, larger passive funds would set aside max of .5 bps. More importantly half of the investor education money (from all schemes) is transferred to AMFI for general education. (This is what pays for the Mutual Funds Sahi Hai ads!) The proposal requires AMFI to use at least 5% of this amount for specific campaigns on ‘passive investment strategy’. (Author’s Note: CP itself says that 1/6 of industry AUM is in passive; the 5% investor education fund is a start but can be higher.)
- CP 14 – Hybrid Index Funds – please see this article – Will the introduction of hybrid index funds be helpful to investors?
- CP 15 – Slightly lighter reporting requirements for transactions made by employees of AMC and trustees in MF Lite
- CP 16 – Disclosures. MF Lite schemes can update the SID within two months of financial year end (currently required twice a year) Debt and hybrid passive schemes can update the portfolio every month, and equity schemes once a quarter. (Currently twice a month and monthly respectively) MF Lite schemes need not provide half yearly financials.
- CP 17 – Permissible products. Passive funds may be allowed to use derivatives of the index constituent if the security is not available for purchase. Stress testing liquidity risk management for passive debt funds may be not applicable. IMPORTANT: MF Lite schemes can not invest in these: unlisted debt, bespoke/complex debt, short selling, inter scheme transactions, unrated debt except govt bills and securities
- CP 18 – Mandate of TE and TD – Important: Currently Tracking Error (TE) has a ceiling for equity schemes, and Tracking Difference (TD) has a ceiling for debt funds. The proposal mandates a strict TD for equity schemes – lower of 1.5 of TER or 1.25%. Since the TER of many index funds is <.4, this puts a good cap on the Tracking Difference.
- CP 19 – Debt Index Replication Factor (DIRF) for debt index funds. Debt funds are permitted, for good reasons, to not fully replicate the underlying index. The proposal requires them to publish the DIRF and gives sample calculations.
- CP 20 – Overseas indices – MF Lite schemes can be launched only on indices specified by AMFI/SEBI. They need to follow the 5/10/40 exposure criteria set by UCITS. Specific ‘popular’ overseas indices would be allowed. Overseas index funds would still be subject to SEBI limits on global AUM. (This proposal may not have much effect as most overseas schemes are inoperative now.)
- CP 21 – Close ended passive debt schemes may be allowed. (Author’s note – previous experience with FMPs makes me wary of close ended schemes in general.)
- CP 22 – Actual choice sought – There are two proposals on what schemes would be under MF Lite. Approach 1 starts MF Lite with the broader indices and adds narrower indices later. Approach 2 permits MF Lite to cover all the existing passive funds, and also new equity indices permitted by AMFI/SEBI. (Author’s note: Not as investor, but as an advisor, I prefer approach 2 as it is simpler.)
- CP 23 – Open ended – This proposal asks for selection of debt indices to be considered under MF Lite. (Author has not studied the implications of this fully. It is interesting to note that almost every debt index fund now seems to be based on a bespoke index used by just that fund!)
Context Interlude
Earlier proposals in the CP cover the structure of MF Lite AMCs. It helps to remember the overall organization of the industry in India.
The structure of the mutual fund industry is reasonably complex and involves many entities. What is typically called the AMC is created by a Sponsor who also appoints a Trustee to keep a watch on the AMC. The actual securities are held by the Custodian and the processing is done by the RTAs. An earlier, but still reasonably correct description can be found here: https://www.jagoinvestor.com/2016/02/mutual-fund-structure-in-india.html
This article also explains the structure of the mutual fund industry and contrasts this with the bank: Can Mutual Funds Fail (go bust) Like Banks?
CP Proposals on Structure
These are in Section I of the CP. For brevity, the context for the proposals are omitted in this article; please see the CP for the context and rationale of the proposals. To repeat, these proposals apply to new entities that want to use MF Lite, or entities spun off from existing AMCs.
- CP1 – Lower networth and experience requirements for MF Lite Sponsors. AMCs under MF Lite can have networth of 50 crores (currently the same), but can bring it down to 25 crores if profitable for 5 years. Important: The sponsors for MF Lite need not have 5 years of experience in the financial services industry. In the alternate eligibility route also has slightly lower criteria. If the AUM exceeds 1 lakh crore, standard criteria would apply.
- CP2 – The core of the proposals and deals with new and existing entities. New players can register under MF Lite and can have only passive schemes. Existing AMCs can hive off ALL their passive schemes to a separate entity which can use MF Lite; in that case the existing AMC should henceforth have only active schemes.
- CP3 – Trustees role. This proposal basically emphasizes the role of trustees in governing the AMCs and says that MF Lite schemes would have the same requirements. (In other words relaxation is for the AMCs and sponsors, but not the trustees.)
- CP4 – Structure of trustees. Most of the structure restrictions are continued for MF Lite. An independent trustee (debenture trustee) can be trustee for more than one MF Lite schemes. The trustee and the AMC can draw up the agreement on roles and responsibilities. Trustee should have sufficient infrastructure and personnel, but they can be shared. Trustees need not form Audit Committee or Risk Management Committee – AMC can do these roles. And more.
- CP5 – Roles of AMC Board – Some roles of the trustees in the typical AMC may be done by the Board of the MF Lite AMC. Most important is the fairness of the expense ratios, and the control of TD and TE. Some control on malpractices including front-running would be jointly done by trustees and AMCs. Similarly some current joint responsibilities – periodic reporting, RMC, etc. – would be done only by the Boards of MF LIte AMCs.
- CP6 – Important: Businesses of MF LIte AMCs. Currently AMCs can, and do, other businesses including PMS. However MF Lite AMCs, since they have easier restrictions, shall do only passive schemes.
- CP7 – Investment Management Agreement – Currently trustees and AMCs do this. For MF Lite, AMFI may offer a standard agreement.
- CP8 – Important – Advertisement Code. If you compare ads from mutual funds and ULIPs, you would know that there are tough advertisement codes for mutual funds. MF Lite schemes, since they don’t have much scope for mis-selling, would have lighter restrictions on ads.
- CP9 – RMC made optional – The Audit committee of the AMC Board can play the role of RMC.
- CP10 – Broker transactions – Currently an AMC can give max 5% of the transactions to the associated broker. Sine MF lite schemes may require volumes to attract brokers, this limit would be 10% for associated broker and 25% for non-associate broker.
- CP11 – SID and KIM – For MF Lite schemes, KIM may be made optional. SID would be further simplified to remove some irrelevant sections – eg investment philosophy. More important parameters for passive schemes – TE, TD, name of index, etc – would be highlighted. All MF Lite scheme SIDs would be through the fast track process.
- CP12 – AMC Reporting – Currently trustees submit the report every 6 months. For MF Lite, the Board can submit a yearly report.
Summary
If you have read this far, it is easy to see that the CP is based on a lot of discussions and suggests steps in the right direction to make it easier for passive funds. Some proposals may be more effective than others; some proposals may need further tuning. But overall, this is a good initiative from SEBI and investors can express their support. The proposals can result in lower TERs for passive funds, and more importantly, lower Tracking Differences.
Please note that there are some players whose interests don’t align with passive funds and they are likely to be vocal in their comments on the CP. Investors can help themselves by voicing their comments on the CP. Again, comments can be given here: https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes.
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