In the last few years, as domestic investor participation in mutual funds has surged, asset managers have looked at new categories and new schemes to attract them. Passive funds have been a big draw for asset management companies as well as investors; over November and December alone, there were close to two dozen scheme launches in this space. Against this backdrop, the Securities and Exchange Board of India has now introduced a new framework for such passively managed schemes of mutual funds.
What are passive funds?
These are funds that typically replicate a specific market index like Sensex, Nifty or Nifty 500. Given that such funds are tracking a specific index, there is no active stock picking by the analyst, like in active funds. In a large-cap index fund, for instance, the fund manager will actively make decisions on which stocks to buy and sell to construct the fund’s portfolio. In a passive fund, like a Sensex Index fund, the investments will made in only the 30 stocks that are components of the Sensex.
Asset managers typically charge significantly lower fees for passive schemes, given that there is little to no active research and stock selection involved here. Given that such funds typically replicate an index, they are also simple to understand.
For these reasons and given that there have been multiple new launches in this space, flows into passive schemes have surged. According to indiapassivefunds.com, NSE’s dedicated website for passive funds, the overall AUM of passive funds was Rs 11.03 lakh crore as of November 2024. While ETF (exchange-traded funds) AUM comprised Rs 8.3 lakh crore, Index funds had an AUM of Rs 2.73 lakh crore.
In the current financial year to November 2024, net inflows into passive schemes have been close to Rs 1.07 lakh crore, significantly higher than the Rs 63,832 crore inflows such schemes saw in the previous 2023-24 financial year.
The extant regulatory framework was the same for active as well as passive funds and didn’t differentiate in the applicability of provisions relating to entry barriers (networth, track record, profits, etc.) and compliance costs for firms launching passive funds.
Securities and Exchange Board of India (SEBI) has now introduced a more relaxed regime, the ‘MF Lite framework’, as it feels various aspects of the existing regulatory framework may not be necessary for passive funds.
The intent, it said, is to “promote ease of entry, encourage new players, reduce compliance requirements, increase penetration, facilitate investment diversification, increase market liquidity and foster innovation.”
Passive funds based on only domestic equity passive indices with a collective AUM of Rs 5,000 crore and above as of December 31 of each financial year will be covered under phase 1 of the implementation of the MF Lite framework.
Similarly, all G-Sec (government securities), T-bills (treasury bills) and SDL (state development loans)-based domestic target maturity debt passive funds and domestic constant duration passive funds based on such debt indices with collective AUM of Rs 5,000 crore and above as on December 31 of each financial year will also be covered under this framework.
All gold and silver ETFs and fund of funds based on gold and silver ETFs, overseas ETFs, and fund of funds having single overseas passive fund will also be covered under the framework in the first phase. However, fund of funds investing in more than one index shall not be covered, SEBI said.
Key provisions of MF Lite
AMCs may appoint a separate chief risk officer (CRO) on a voluntary basis, otherwise the chief compliance officer may also act as the CRO of the AMC, subject to her eligibility and experience in risk management. Private equity funds can sponsor an MF Lite as well.
The net profit of the AMC after providing for depreciation, interest and tax in three out of the immediately preceding five years and the average net annual profit after providing for depreciation, interest and tax during the immediately preceding five years should be at least Rs 5 crore.
An MF Lite AMC shall abide by net worth requirements under Chapter IV of MF Regulations, as and when the total AUM of the MF Lite AMC exceeds Rs 1 Lakh crore.
Existing MFs having both active and passive schemes may hive off respective passive schemes covered under the MF Lite framework, if they so desire, to a different group entity, thereby resulting in the management of active and passive schemes by separate AMCs but under a common sponsor.
MF Lite AMCs will not be required to file a separate key information memorandum for the respective scheme. The scheme information documents (SID) of mutual fund schemes have also been simplified.
Further, equity passive schemes will have to disclose their scheme portfolio within 10 days of the close of each quarter, and separate portfolio disclosures of passive schemes on a half-yearly basis will be done away with.
Passive schemes will not be allowed to invest in unlisted debt instruments, complex debt products, securities with special features, short-selling and unrated debt and money market instruments.
AMCs have been allowed to launch a new class of hybrid passive funds, which replicate a composite index comprising equity and debt. AMCs will also now be able to launch close-ended debt passive schemes.
The MF Lite provisions will come into effect from March 16, 2025.
Who benefits from MF Lite?
MF Lite is simplifying the entry process and could attract new players into the industry. In the last 2-3 years, several fintech startups have entered the market with plans to launch passive-only schemes. Reduced compliance regulations will give them a boost. It should lead to more market liquidity and expand the market.
The introduction of MF Lite will also be beneficial from a retail investor perspective. New players will mean new schemes and, hopefully, more differentiated offerings. Also, reduced compliance and increased competition with new players should also eventually bring down costs over time, making investing in such passive schemes even more affordable.
