According to AMFI data, the AUM of passive funds in India has crossed Rs5 trillion. What is more interesting is that the AUM grew 60% in the year 2021 and is expected to sustain that momentum in 2022 also. What exactly do we understand by passive funds?
As the name suggests, a passive fund has no active management. The fund manager does not decide what stocks to buy and what stocks to sell or how much to allocate to each stock. A typical passive equity fund will be pegged to an index like the Nifty. So it will create a portfolio of all stocks in the Nifty in the same proportion. The portfolio will only change when the Nifty constituents or weightage changes.
There are several advantages in passive investing. Globally, 80% of the active fund managers have struggled to beat the index and that trend is visible in India also in the last couple of years. Secondly, since passive funds do not have an active component, they don’t need active fund managers. Hence the cost of operating a passive fund is much lower, which translates into lower expense ratio. Lastly, passive fund mirror the index and remember the Sensex has given 16.5% CAGR returns over last 42 years; without counting dividends.
Before we get into the recent changes announced by SEBI on passive funds, remember that these passive funds can pegged to equity or debt. Just as an equity ETF can be pegged to the Nifty, a debt ETF can be pegged to a debt market index. To boost passive funds as an asset class, SEBI has announced a slew of measures.
Key measures announced by SEBI for passive funds
While the provisions for passive fund regulation have been announced, these changes will only take effect from 01st July onwards.
In a significant shift, SEBI permitted the launch of passive ELSS schemes. The ELSS funds are equity funds with 3 year lock-in that also provide tax exemption under Section 80C of the Income Tax Act. However, ELSS Funds had to be active equity funds by default. Effective 01st July 2022, AMCs will be allowed to launch passive ELSS so that even conservative investors can participate in profitable tax saving. The index has to be from among the top 250 companies. However, the SEBI announcement has been silent about extending the tax exemption to debt schemes too. Also, any AMC can either launch an active ELSS or a passive ELSS, but not both.
Currently debt ETFs are permitted subject to the condition that passive debt funds can only invest in AAA rated bond portfolios. This narrows the choice and also caps the yield on such funds. To address this issue. SEBI has allowed the classification of passive debt funds into 3 distinct categories viz. corporate debt funds, G-Sec Funds and Hybrid combination funds. This will widen the choice and also allow passive fund to offer permutations to customers based on risk and return profile.
An important change is on the disclosure of NAVs in the case of passive funds and passive index ETFs. For many ETFs, there is no real time disclosure of NAVs. As a result the ETF market price tends to diverge from the underlying NAV. Now, SEBI has mandated the requirement of disclosing indicative NAVs through the day. In the case of illiquid underlying, the standard capitalization formula can be applied. That way, investors buying ETFs have access to real time NAV information to make more transparent and informed buy and sell decisions.
Apart from the above 3 changes, SEBI has made important changes to the reporting and disclosure of tracking error. We look at it as a separate header.
Tracking error (TE) and Tracking Difference (TD)
Before getting into the actual changes made by SEBI on TE and TD, let us look at what Tracking Error and Tracking Difference are all about. In simple terms, the Tracking Error is the extent to which the fund/ETF returns fail to mirror the index returns. Some tracking error will always be there since the expense ratio reduces returns on a passive fund and a passive portfolio will never be fully in sync with the index. The concept of Tracking Error and Tracking Difference has been best explained by Vanguard Funds.
According to Vanguard Funds, “Tracking difference shows how an ETF/index fund performance compares with the benchmark index over a period of time”. On the other hand, “Tracking Error shows the consistency of the Tracking Difference during the same period. In other words, Tracking Error is the annualized standard deviation of tracking difference for a given period of time”. The bottom line is that if your primary criterion is total return, then Tracking Difference is more relevant and if the consideration is consistency, then Tracking Error is a better measure.
Let us now turn to what SEBI has announced on this subject. Effective 01st July, the AMCs managing passive non-debt funds (ETFs / index funds) must ensure that the Tracking Error (TE) does not exceed 2% based on last one year data. This tracking error will be calculated on a rolling basis every day. In addition, these ETFs / index funds must also ensure that the Tracking Difference (TD) based on one-year data must not exceed 1.25%. Failure to meet these limits must be immediately reported to the MF trustees and corrected.
Passive Funds will also have to now publish their one-year Tracking Error (TE) on a daily basis and the Tracking Difference (TD) must be disclosed on a monthly basis. The TD will be disclosed for multiple time frames like 1 year, 3 years, 5 years, 10 years and since inception. This is likely to make these passive funds more transparent with mandatorily higher disclosure standards.
Why these changes are material?
In his 2016 annual letter to shareholders, Warren Buffett lauded the efforts of Jack Bogle of Vanguard. Buffett underlined that Vanguard passive funds had saved close to $1 trillion in mutual fund fees for investors. For that kind of volumes in passive funds to come to India, there is the need for big drivers like Vanguard and Blackrock as well as a supportive regulatory framework. That is the first gap that SEBI has sought to fill.
Index ETFs are about a more conservative approach to risk assets. An index does away with the unsystematic risk in investing and makes it more disciplined and structured. Hopefully, these SEBI changes should give that much needed boost to the passive investing ecosystem in India.