SEBI Issues Norms for Debt Index Funds and ETFs: All You Need to Know

May 28, 2022 Mutual Fund

Passive Funds such as Exchange-traded Funds (ETFs) and Index Funds have gained a lot of momentum in the last few years. Mutual funds have launched a spree of passive funds in recent years to offer investors the benefit of diversification at a low cost.

In the debt fund category, too, AMCs have launched quite a few passive funds, mainly in the target maturity segment. Taking this into consideration, the market regulator SEBI has announced several guidelines for the smooth functioning and uniformity of Passive Debt Funds.

Here are the key points that you need to know:

Mutual fund houses that launch Debt ETFs or Index Funds should categorise them based on either of the following indices:

(a) Corporate Debt Securities (Corporate debt indices); or

(b) Government Securities (G-sec), T-bills, and/or State Development Loans (SDLs) (G-sec indices); or

(c) A combination of Corporate Debt Securities and G-sec/T-bills/SDLs (Hybrid debt indices).

This can potentially make it easier for investors to select the most suitable scheme based on their risk-return profile.

[Read: RBI Hikes Interest Rate. What Should be your Debt Mutual Fund Strategy Now?]

Single issuer limit

To avoid concentration risk, SEBI has prescribed a single issuer limit for indices as follows:

a) For an index with at least 80% weight of corporate debt securities, the single issuer limit will be as under:

1. In the case of AAA rated securities, a single issuer should not have more than 15% weight in the index.

2. In the case of AA rated securities, a single issuer should not have more than 12.5% weight in the index.

3. In the case of A and below rated securities, a single issuer should not have more than 10% weight in the index.

b) For a hybrid index (comprising both corporate debt securities and G-sec/SDL) with up to 80% weight of corporate debt securities, the single issuer limit will be as under:

1. In the case of AAA rated securities, a single issuer should not have more than 10% weight in the index. However, for AAA rated securities of Public Sector Units (PSU) and Public Finance Institutes (PFI) issuers, the said limit shall be 15%.

2. In the case of AA rated securities, a single issuer should not have more than 8% weight in the index.

3. In the case of A and below rated securities, a single issuer should not have more than 6% weight in the index.

c) Single issuer limit will not be applicable for index based on G-sec and SDLs.

Furthermore, the index should not have more than 25% weight in a particular sector (excluding G-sec, T-bills, SDLs, and AAA rated securities issued by PSUs, PFIs, and PSBs).

To ensure smooth implementation of the above-mentioned guidelines, AMFI will soon issue a list of debt indices for the launching of debt ETFs/Index Funds.

Guidelines for Debt ETFs/Index Funds based on the index of corporate debt securities

A Debt ETF/Index Fund based on an index comprising only corporate debt securities will be considered to be replicating the underlying index provided:

i) Investment in securities of issuers accounting for at least 60% of weight in the index represents at least 80% of the net asset value (NAV) of the ETF/Index Fund. This norm will also be applicable to Hybrid Debt ETF/Index Fund based on an index comprising more than 80% weight for corporate debt securities.

ii) The securities of issuers that are not part of the underlying index should not exceed 20% of the NAV of ETF/Index Fund at any point of time. This norm will also apply to Hybrid Debt ETF/Index Fund portfolio comprising up to 80% weight of corporate debt securities.

iii) At least 8 issuers from the underlying index should form part of the ETF/Index Fund.

Replicating the duration of the underlying index

The ETF/Index Fund has to replicate the duration of the underlying index within a maximum permissible deviation of +/- 10%.

In the case of Target Maturity ETFs/Index Funds, the permissible deviation will be as follows:

a. For a portfolio with residual maturity of greater than 5 years — either +/- 6 months or +/- 10% of duration, whichever is higher.

b. For a portfolio with residual maturity of up to 5 years — either +/- 3 months or +/- 10% of duration, whichever is higher.

c. The residual maturity of any security forming part of the portfolio should not exceed the target maturity date of the ETF/Index Fund at any point of time.

Replicating the rating allocation of the underlying index

The rating wise weightage of debt securities in the portfolio of ETF/Index Fund should replicate that of the underlying index. However, a greater allocation of up to 10% of the portfolio can be made in the case of higher-rated debt securities.

Additional norms

The positioning of the ETF/Index Fund in the Potential Risk Class (PRC) matrix should be the same as the positioning of the index at all points of time.

Any transactions undertaken in the scheme portfolio of ETF/Index Fund in order to meet the redemption and subscription obligations should be done while ensuring that post such transactions, replication of the portfolio with the index is maintained at all points of time.

Rebalancing norms

a) In the case of change in constituents of the index due to periodic review, the portfolio of ETF/ Index Funds should be rebalanced within 7 calendar days.

b) In the case the rating of any security is downgraded to below the rating mandated in the index methodology (including downgrade to below investment grade), the portfolio should be rebalanced within 30 calendar days.

c) In the case the rating of any security is downgraded to below investment grade, the said security may be segregated in accordance with the SEBI circular on ‘Creation of segregated portfolio in mutual fund schemes’.

Norms for enhancing liquidity in ETFs

AMCs will have to appoint at least two Market Makers (MMs), who are members of the Stock Exchanges, for ETFs to provide continuous liquidity on the stock exchange platform. MM shall transact with AMCs only in multiples of creation unit size (blocks of shares).

Furthermore, direct transactions with AMCs will be facilitated for investors only for transactions above a specified threshold. In this regard, to begin with, any order placed for redemption or subscription directly with the AMC must be greater than Rs 25 crore. This threshold will not be applicable for MMs and will be reviewed periodically.

To conclude:

Replicating debt indices is not as straightforward as replicating equity indices as it involves replication of issuer, duration, rating, maturity, etc. SEBI’s norms for passive debt funds explain in detail how each of these components should be formed to ensure proper replication of the underlying index.

The provisions of the circular will come into force with effect from July 01, 2022, and will be applicable to all existing ETFs/Index Funds.

This article first appeared on PersonalFN here