[Yash Vardhan and Yuman Islam are 5th year students at Gujarat National Law University, Gandhinagar]
The Securities and Exchange Board of India (“SEBI”) recently released a consultation paper introducing new regulations for passively managed mutual funds. The proposed regulations are called the “MF Lite Regulations.” This proposal aims to establish a more flexible regulatory framework for passive funds, compared to the current regulations, which are primarily tailored for actively managed mutual funds. While the SEBI’s initiative aims to foster innovation, encourage competition, and ease the entry of new players, the proposal raises some concerns about its potential impact on market dynamics and investor protection, which we highlight in this article.
Background
Mutual funds in India are currently governed by the SEBI (Mutual Funds) Regulations, 1996, which apply uniformly to both active and passive schemes. However, the complexities and risks associated with actively managed funds necessitate a stringent regulatory approach, which may not be entirely relevant for passive funds.
Passive mutual funds are investment vehicles that replicate the performance of a specific index. Passive mutual funds, such as Index Funds, replicate the composition of underlying indices, such as NIFTY or SENSEX, leading to a reduced risk profile compared to active funds, which involve fund managers identifying individual stocks for investment. A key benefit of passive mutual funds for investors is their low management cost due to minimal trading and lower research expenses. This has led the SEBI to propose a differentiated regulatory framework to cater specifically to passive schemes.
As per the SEBI, the simplicity and lower risk associated with passive mutual funds justify a more relaxed regulatory framework. The existing regulations, designed primarily for active funds, impose substantial compliance and entry barriers that may not be relevant for passive funds. By introducing MF Lite regulations, the SEBI aims to encourage new players, foster innovation, and enhance competition in the mutual funds industry. This approach is expected to facilitate greater market penetration and diversification of investment options for investors.
Key Recommendations
Ease of Entry for New Passive Mutual Funds
a. Eligibility Criteria for MF Lite
The consultation paper proposes more lenient eligibility criteria for entities seeking to launch passive mutual funds under the MF Lite framework. Unlike the stringent financial track record and profitability requirements for active fund sponsors, the MF Lite criteria focus on reducing the net worth and experience prerequisites, thereby lowering the entry barriers for new entrants. It proposes a minimum net worth requirement of Rs. 35 crores for Asset Management Companies (“AMCs”) under the main eligibility route, all of which must be deployed in liquid assets. For the alternative route, the minimum net worth is set at Rs. 75 crores, which is also to be deployed in liquid assets.
b. Shareholding, Governance, and Trustees in Mutual Funds
SEBI recommends revising shareholding norms to allow more flexibility in the governance structure of passive mutual funds. This includes potential adjustments to the minimum net worth requirements for AMCs and reducing the lock-in period for sponsors’ shareholding, to attract serious players to the market. The Boards of AMCs managing passive funds would also see a relaxation in their regulatory obligations. This includes fewer requirements for board meetings and simplified reporting standards.
The consultation paper proposes that the roles and responsibilities of trustees in the MF Lite framework should be somewhat relaxed compared to those under the current regulatory framework for actively managed schemes. However, the extant regulations will still oversee critical areas such as related party transactions, conflicts of interest, undue influence by sponsors, and misconduct, including market abuse and misuse of information.
c. Simplified Scheme Information Document
The consultation paper proposes further simplifications to the Scheme Information Document (“SID”) for passively managed schemes, building on the SEBI Circular from November 1, 2023, which aimed to simplify and streamline offer documents for all mutual fund schemes.
The proposed SID modifications include removing parameters irrelevant to passive schemes, such as investment strategy, types of instruments, and benchmark performance, which are pertinent only to active schemes. Instead, other relevant parameters for passive schemes, such as tracking error, tracking difference, an underlying benchmark name, and specific attributes of target maturity debt passive schemes, will be highlighted in the SID. Furthermore, the requirement for a separate Key Information Memorandum (“KIM”) filing will be relaxed, enhancing the efficiency and accessibility of essential information for investors.
Ease of Compliance, Relaxed Disclosures, and Other Regulatory Requirements
a. Investor Education and Awareness
The consultation paper underscores the importance of investor education and awareness in promoting passive mutual funds. SEBI proposes targeted initiatives to educate investors about the benefits and risks of passive investing, ensuring informed decision-making.
b. Introduction of Hybrid Exchange Traded Funds (“ETFs”)/Index Funds
To further diversify the passive fund offerings, SEBI suggests the introduction of hybrid ETFs and Index Funds, which combine elements of both passive and active management, allowing investors to invest in a single product with exposure to both equity and debt instruments. These Hybrid ETFs or Index Funds will track an index that includes a combination of domestic equity and debt indices.
Initially, only three sets of hybrid passive schemes will be eligible for the MF Lite Regulations: debt-oriented (25:75 equity to debt), balanced (50:50 equity to debt), and equity-oriented (75:25 equity to debt). These hybrid products could offer investors a balanced approach to risk and return.
c. Compliance and Disclosure
SEBI recommends relaxed compliance and disclosure norms for passive schemes under existing mutual funds as well as those launched under the MF Lite registration. This includes reduced frequency of reporting and simplified compliance processes aimed at lowering operational costs for fund managers.
d. Investments by Passive Schemes
The paper also addresses the investment norms for passive schemes, proposing more flexible investment guidelines that allow passive funds to invest in a broader range of securities while maintaining their index-tracking mandate.
Implementation
The SEBI Working Group proposed two approaches for passive schemes under the MF Lite Regulations. Approach 1 involves phased implementation, initially allowing only domestic equity passive indices with Assets under Management (“AUM”) of over Rs. 10,000 crores or Rs. 5,000 crores and specific overseas indices. This would encourage serious players and prevent index proliferation but limit MF Lite to certain passive schemes while others remain under the current regulations.
Approach 2 involves uniform implementation, including all existing ETFs and Index Funds under MF Lite with new equity passive schemes. This ensures uniform regulations and offers diversified investment opportunities with greater flexibility.
Analysis
Positive Impacts on the Industry
a. Increased Market Access and Democratisation
SEBI proposes a reduction in net worth and experience requirements for sponsors and AMCs. By lowering the financial thresholds and experience prerequisites, SEBI aims to attract new players to the passive mutual funds market. This can help increase the competition and provide a wider range of investment options for investors. Given that the role of AMCs in passive funds is minimal, the reduced net worth criteria align with the low-risk nature of these funds.
b. Reduced Tracking Difference
The SEBI also proposes standardized norms for Tracking Difference (“TD”) and Tracking Error (“TE”) to enhance passive fund effectiveness. TD is defined as the difference in daily returns between the index fund and the benchmark index being tracked by the fund, while TE is the annualized standard deviation of this difference. Reducing TD offers significant advantages for investors. It ensures the fund’s returns closely match the benchmark, enhancing long-term returns and leveraging the compounding effect over time.
At present, there is a ceiling for equity schemes in TE and a corresponding ceiling for debt funds in TD. The new proposal mandates a stringent limit for equity schemes in TD, which is 1.5 times the Total Expense Ratio (“TER”) or 1.25%, whichever is lower. The maximum TER for the passive funds is set at 1%. However, given that many index funds have a TER much lower than this, the TD limits will effectively benefit the investors.
c. Disclosures and Enhanced Transparency
SEBI aims to significantly reduce the compliance and disclosures for passive funds compared to active funds. This might help reduce compliance costs for the AMC, which could further translate to a lower TER for the investors. SEBI also proposes new disclosures in the SID for passive funds, specifically on TE and TD. Since they are more relevant from the passive mutual funds’ standpoint, these metrics are not available in extant mutual fund regulations. Clear and consistent updates on the alignment of a fund with its benchmark index will provide investors with transparency and enhanced insights into performance.
Road Ahead
While SEBI’s initiative to introduce MF Lite Regulations appears well-intentioned, several critical aspects warrant closer examination.
a. Introduction of Hybrid ETFs/Index Funds
The proposal to introduce hybrid ETFs and Index Funds, combining elements of passive and active management, is an innovative step. However, it may lead to confusion among investors regarding the risk and return profiles of these products. Hybrid funds, by their nature, involve a mix of passive tracking and active management strategies, which can blur the lines between the two approaches. Clear and comprehensive guidelines are necessary to ensure investors understand the nuances of hybrid products. Additionally, extensive investor education campaigns are crucial to prevent misinterpretation and ensure informed investment decisions.
b. Investor Education
The new proposal stipulates that the Association of Mutual Funds of India (“AMFI”) must allocate at least 5% of the investor education funds specifically towards campaigns that promote the understanding of passive investment strategies. Notably, in the consultation paper, SEBI indicates that 1/6th (i.e., 16.66%) of the industry’s AUM are in passive schemes. Hence, while the proposed 5% allocation for investor education is a positive step, it is suggested that this percentage could be increased to more effectively educate investors about passive investment mutual funds.
c. Impact on the Market
As stated previously, the SEBI proposes two approaches for implementing this regulation. However, this post argues that the second approach, that is, uniform application of the regulations, is better for the growth and competition in the market instead of phased application. The first approach, allowing existing mutual funds with a certain minimum threshold to benefit from the relaxed provisions, could create an uneven playing field. Established players with significant resources might leverage these relaxations to dominate the passive fund segment, potentially stifling the entry and growth of smaller, newer players.
Conclusion
SEBI’s proposal to introduce MF Lite Regulations represents a significant shift in the regulatory landscape for passive mutual funds in India. While the intention to ease entry and reduce compliance for passive mutual funds is commendable, the proposed framework raises several concerns that need to be addressed. Ensuring investor protection, maintaining the financial stability of AMCs, and creating a level playing field for all market participants are critical aspects that must be carefully considered. A balanced approach that fosters innovation and competition while safeguarding market integrity and investor interests will be crucial for successfully implementing these regulations.
– Yash Vardhan and Yuman Islam
