India’s Passive Fund Revolution: Decoding SEBI’s Consultation Paper on MF Lite Regulations

July 4, 2024 Mutual Fund

The financial landscape is evolving rapidly, driven by technological advancements, regulatory changes, and the growing sophistication of investors. One of the significant developments in recent times is the Securities and Exchange Board of India (SEBI) consideration of introducing Mutual Funds Lite Regulations (MF Lite) for passively managed mutual fund schemes.

SEBI, the market regulator, wants to make it simpler for new participants to enter the mutual fund industry and offer passive products. On July 01, 2024, the capital market regulator SEBI issued a consultation paper proposing the implementation of Mutual Fund Lite regulations (MF Lite) for passively managed mutual fund schemes.

[SEBI Consultation Paper: Introduction of Mutual Funds Lite Regulations for Passively Managed MF Schemes]

The new guidelines are specifically aimed towards the fund houses that exclusively offer passive investment options like Exchange-Traded Funds (ETFs) and index funds.

The primary goal of this paper is to solicit public feedback on recommendations for implementing a more flexible regulatory framework in the Mutual Funds (MF) segment for passively managed mutual fund schemes.

Rationale Behind SEBI’s Consultation Paper…

Mutual funds have long been a popular investment vehicle, offering diversification, professional management, and accessibility to a wide range of asset classes. Traditionally, mutual funds can be broadly categorized into actively managed and passively managed schemes.

Actively managed funds rely on the expertise of fund managers to make investment decisions, while passively managed funds, also known as index funds, aim to replicate the performance of a specific market index. In recent years, the popularity of passively managed funds has surged, driven by their lower costs, transparency, and simplicity.

This trend has prompted regulators and industry participants to consider tailored regulations that address the unique characteristics of these funds. The introduction of MF Lite regulations is a response to this evolving landscape, aiming to create a regulatory framework that facilitates the growth and development of passively managed mutual fund schemes.

[Read: SEBI Plans to Reduce Compliance Checks for Passive Funds with Mutual Fund Lite Regulations]

SEBI had constituted a Working Group (WG) comprising of various stakeholders including MF industry participants, to study various aspects of the extant regulatory framework for MFs and recommend a relaxed regime for passively managed schemes.

Let us have a look at the few key points stated in SEBI’s Consultation Paper:

1. Introduction of Hybrid Passive ETFs/Index Funds

According to SEBI’s WG discussion, the regulatory provisions currently allow passive funds to replicate only a debt index or an equity index, with no framework in place to replicate a hybrid index, which is a composite build of a debt and equity index.

It is thus planned to establish Hybrid passive funds, which will replicate a composite index with set proportions of equity and debt and allow investors to invest in a single product with exposure to both equity and debt securities. It is believed that the inclusion of the same will provide further flexibility and diversification opportunities within the passive funds market.

The proposed framework for hybrid passive schemes is as under:

There will be three sets of hybrid passive schemes with the following features

A mutual fund will launch a maximum of one scheme per category of hybrid funds.

Section I of this consultation paper deals with the proposals pertaining to the entities intending to get registration under the MF Lite Regulation to launch only passively managed schemes. As stated in SEBI’s consultation paper dated July 01, 2024, the entities registered under MF Lite may not be allowed to do any asset management business activity.

The market regulator has also proposed lower net worth and profit requirements for sponsors and fund houses wishing to launch passive funds only.

If the proposal is successfully accepted, here are some rules stated by SEBI for a sponsor to launch a fund house or AMC under the main eligibility route in the proposed MF Lite framework:

• The sponsor should have a positive net worth in the preceding 5 years.
• They should also have a net profit after tax (PAT) in three out of the last 5 years, including the 5th year.
• SEBI has proposed that the sponsor’s average profit in the last 5 years should be at least Rs 5 crore. Currently, the requirement is Rs 10 crore.
• Meanwhile, the fund house needs to ensure that its minimum net worth is Rs 35 crore. The net worth can be brought down to Rs 25 crore if it registers profits for five successive years.

The sponsor may also consider launching a fund house through an alternate eligibility route. In this situation, they must ensure that the fund house has a minimum net worth of Rs 75 crore. Currently, fund houses must have a net value of Rs 150 crore.

Furthermore, passive-only AMCs would be allowed to conduct up to 10% of transactions through linked brokers, which is an increase from the previous maximum of 5%.

In addition, the minimum combined experience required for the Chief Executive Officer (CEO), Chief Operating Officer (COO), Chief Compliance Officer (CCO), and Chief Investment Officer (CIO) of passive-only AMCs is set to be reduced to 20 years from the current requirement of 30 years.

2. Simplified SID & KIM for Passive Mutual Funds

The proposal also aims to streamline SID, a document that provides investors with comprehensive information about a mutual fund scheme.

Given the low risks associated with passively managed schemes, parameters such as investment strategy, instruments in which schemes may invest, and scheme benchmark performance will be omitted from the SID.

However, significant parameters such as tracking error, tracking difference, and the name of the underlying benchmark must be included in the SID.

According to current requirements, SIDs must be updated within six months after the end of the first and second half of the fiscal year in which the schemes were launched, using the relevant data and information as of the end of the previous month. It is proposed that SID for passive schemes may be updated within 2 months from the end of the financial year.

3. Relaxed Portfolio Disclosure Norms

The portfolio disclosure norms for passive funds shall be relaxed under the MF Lite framework as follows:

• Debt and hybrid passive schemes: monthly basis within 10 days of every month from fortnightly basis at present
• Equity passive schemes: within 10 days from the close of each quarter from disclosing on a monthly basis earlier
• Separate disclosure on a half-yearly basis may be done away for passive funds as the same is already incorporated in the monthly and quarterly disclosure of Debt (& hybrid) and equity passive schemes.

Currently, AMCs are allowed to launch equity and debt-oriented passive schemes based on equity and debt indices only. Further, AMCs can manage commodity-based ETFs based on only gold and silver commodities.

4. Launch of Close-ended debt passive schemes

Moreover, it is proposed that an option for launching of closed-ended debt passive scheme may be enabled.

Currently, there are target maturity debt passive schemes in existence, wherein the index of the scheme matures on a particular date and after that, the fund also expires. However, such schemes are open-ended as the investors may subscribe or redeem at any time during the life of the fund.

Market participants can share their views before July 22, 2024, the comments may be submitted through the following link:

https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes

To conclude…

The introduction of Mutual Funds Lite Regulations (MF Lite) marks a significant milestone in the evolution of the mutual fund industry. These regulations are designed to create a more accessible, cost-effective, and transparent environment for passively managed mutual funds, offering numerous benefits to investors like you.

SEBI’s proposed MF Lite framework carries the potential to revolutionize India’s passive fund landscape. By fostering innovation, competition, and potentially lower costs, it could lead to a more vibrant and inclusive investment ecosystem. However, careful consideration of potential drawbacks and a focus on investor protection are essential.

This article first appeared on PersonalFN here