Capital Markets: Challenges and Developments

Understanding SEBI Rules on Passive Funds


From UPSC perspective, the following things are important :

Prelims level: Passive Funds

Mains level: Not Much

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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