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Are new Sebi rules for ETFs, index funds good for you?

IndianMoney.com Research Team | Posted On Wednesday, February 06,2019, 05:24 PM

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Are new Sebi rules for ETFs, index funds good for you?

 

 

What is SEBI?

SEBI is the Securities and Exchange Board of India, which is the regulatory board for the security market in India. SEBI was founded in 1988 and given statutory powers on 30 January 1992 through the SEBI Act, 1992. SEBI is headquartered at Mumbai, the financial capital of India. SEBI has Southern, Eastern, Western, and Northern Regional Offices at Chennai, Kolkata, Ahmedabad and New Delhi respectively. SEBI has local offices at Jaipur and Bangalore.

The chairman of SEBI is nominated by the Union Government of India. Two officers from the Union Finance Ministry are nominated to be a part of SEBI as members. One officer from the Reserve Bank of India is nominated for the membership of SEBI. The remaining 5 members are directly nominated by the Union Government of India, out of which at least three are full time members. Currently, Ajay Tyagi  is the chairman of SEBI.

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What is ETF?

Exchange-traded fund ETF, is an investment fund traded in stock exchanges, just like stocks. An Exchange-traded fund includes assets such as commodities, stocks, or bonds and usually operate based on an arbitrage mechanism which is designed to keep trading close to its net asset value. However, deviations do occur, but not often.

Advantages and Disadvantages of ETFs

Below mentioned are the advantages of ETFs:

·      Buy and sell at any time of the day: Mutual funds, in contrast, settle after the market closes

·      Lower fees: There is very minimal managing charges with applicable brokerage

·      More tax efficient: Capital gains tax is lower when compared to other funds

·      Trading transactions: They are traded just like stocks, investors can place a variety of types of orders (limit orders, stop-loss orders, buy on margin). Mutual funds don’t allow this.

Below mentioned are the disadvantages of ETFs

·      Trading costs: There are other low cost alternatives if you are to invest in small amounts frequently.

·      Illiquidity: Few thinly traded ETFs have large bid/ask spreads, which means you buy at a higher price of the spread and sell at a lower price of the spread.

·      Tracking error: ETFs are not completely error free. Tracking errors are seen occasionally.

·      Settlement dates: You cannot reinvest the funds from an ETF sale for at least two days.

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The new rules of ETF

To mitigate risks in the portfolio concentration in equity exchange traded funds (ETFs) and index funds, SEBI has asked fund houses to have a wider basket of stocks. SEBI has directed equity ETFs and index funds to have at least 10 stocks as its constituents.

SEBI also capped the weightage of top stocks in the index. A single stock cannot have a weightage of more than 35% for a sectoral or thematic index. In case of other indices, each stock is capped at 25%. Apart from capping on the weightage, SEBI also mandated that the cumulative weightage of top 3 stocks in the index cannot be more than 65%.

Securities and Exchange Board of India further mandated that the individual constituents of the index must have a trading frequency of minimum 80% and an average impact cost of 1% or lesser over the last six months.

Any index fund or exchange traded fund trying to replicate an index, must ensure that such index comply with the above mentioned norms. SEBI is of the opinion that these changes would address and mitigate the risks involved in portfolio concentration in index funds and exchange traded funds.

The fund houses are to evaluate and ensure the compliance with the latest norms at the end of each quarter. The fund houses must publish this data publicly on their official websites. The data published must contain the information related to weightage of all individual constituents of the index, at all times.

SEBI has asked all issuers of existing equity ETFs and index funds to comply with the new rules within three months from 10th Jan 2019. The new funds are mandated to submit their compliance status to SEBI before their launch.

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THE IMPLICATIONS

The risk of concentration that SEBI is looking to mitigate currently exists in a few sectoral indices. Exchange traded funds and index funds tracking Nifty bank index, Nifty PSU bank index and Nifty infrastructure index are few portfolios that are to be redesigned for their compliance with the latest norms as mentioned before.

Those index funds and exchange-traded funds tracking bellwether indices like Sensex or Nifty 50 or any other broad market indices, will have no impact due to the latest guidelines laid down by the regulatory body. This is because the individual weight, as well as the cumulative weightage of its top three constituents, is well below the prescribed limit of 25% and 65% respectively.

Index funds and exchange traded funds are mandated to report compliance status to SEBI at the end of each quarter. They are also mandated to display the list of stocks and their weightage in the index on their official websites at all times.

To adopt these changes, the first move is to redesign the index, this has to be done by index providers. After the compliance is attained, passive funds would realign the portfolios in line with the new index. The biggest challenge would be to submit a compliance report on quarterly basis.

Indices are traditionally rebalanced once every six months, but the latest mandate is demanding a compliance report at the end of each quarter. As the portfolios of index funds are to be aligned with the underlying indices, there might be reviews needed for the periodicity. Frequent reviews may result in higher costs of rebalancing the portfolios. However, there will be no compromise on the quality of stocks coming into the index due to new guidelines laid down by the regulatory body. This is because there are additional filters applied on defining the upper limit on impact cost and minimum trading frequency to ensure that quality stocks are coming into the index.

A major side-effect of the new guidelines would be the excess supply of a few stocks being in the market as affected funds decrease the weightage once the indices are redesigned to be compliant under the SEBI’s new guidelines.

With the assets under management involved are small, stocks whose weightage in the portfolios are to be reduced, like SBI and HDFC Banks, have benefits of high level of liquidity and investors’ interest. The market must be in a position to absorb the excess supply without causing much of an impact on prices.

Conclusion

It is not good to put a capping on the weightage of stocks of an index that is performing well, especially in the case of bellwether indices that are deemed as economic indicators. At the same time, it is critical to balance it against the diversification.

The latest guidelines set by the regulatory body can be considered as a positive development for investors as it improves the level of risk mitigation of the index funds and exchange traded funds by being more representative of the market. Regulations that clearly define the filters based on which the index portfolios are constructed would assist investors in building their portfolios in a much better way.

A broader portfolio with quality stocks and lower costs tagged with passively managed funds is expected translate into better experience for investors.

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