The Securities and Exchange Board of India has issued new norms for index funds and ETFs in both equity and debt space. The 16-page circular covers a lot of ground from equity FoFs to regulations on passive corporate bond funds. The circular also paves way for passive ELSSs. Shivani Bazaz of ETMutualFunds reached out to Niranjan Awasthi, Head-product, marketing and digital businesses, Edelweiss NSE 3.89 % Mutual Fund, to decode the circular. Edited Interview.

WHAT ARE THE MOST IMPORTANT ASPECTS OF THE SEBI CIRCULAR?

The first important point is increasing liquidity in ETFs and in the entire exchange. One, Sebi has put a limit of Rs 25 crore worth of transactions with the AMC. So, direct transactions with AMCs shall be facilitated for investors only for transactions above a specified threshold. So any redemption or subscription directly with the AMC must be of greater than Rs 25 crore. This brings more people to the exchange directly. Now, to cater to this huge demand, you need market makers, which is another important norm.

Sebi has made it mandatory for every AMC to appoint two market makers. They have also allowed AMCs as well as the exchanges to incentivize the market markers The news norms also reduce the price risk for the market makers. This allows them to provide better liquidity. All these things will improve liquidity and transparency in ETFs. I think this move is largely to move towards a developed market situation. In developed markets, the entire liquidity is handled by market makers. AMCs rarely deal directly with investors. So, all this is a trial to replicate the functioning of a developed market in some way.

BREAKING IT DOWN FURTHER, HOW DO MARKET MAKERS WORK AND WHAT PURPOSE DO THEY SERVE IN A MARKET?

See, ETFs are traded on the exchange and there should be liquidity in the exchange to trade these ETFs. Just like any other stock. The big-ask spread is very narrow and the trade can happen much closer to the fair price. In absence of market makers, this spread widens. At times, there could only be a bid on an ETF and no ask. In such cases, the market makers chip in and create the second leg of order either on the bid side or on the ask side.

The aim of market makers is to reduce the bid-ask spread and also keep the ETF prices closer to the fair value. So, the impact cost of buying an ETF for an investor is reduced. In a nutshell, the presence of market makers will reduce the cost of trading in ETFs.

ARE LOWER COSTS AND INCREASED LIQUIDITY GOING TO ATTRACT MORE RETAIL INVESTORS? THESE INVESTORS USUALLY PREFER INDEX FUNDS, BUT ARE THE NEW NORMS GOING TO BRING THEM TO THE ETF FOLD?

Index funds and ETFs, both have their own benefits and drawbacks. The benefit of an ETF is that since it is traded on the exchange, you can follow the true prices but you would need to know to trade. You would need a Demat account. Index funds are easy, you don’t need any expertise for them.

Investors who understand and want to invest via ETFs will find these norms make lives easier. Those who are intently going for index funds have many different needs. They have to set up SIPs and SWPs, they don't want to go via a brokerage and they are fine with end of the day valuation. For retail investors who want to take it easy, index funds are still a lucrative option. For savvy investors and traders, ETFs have become better.

ARE THE NORMS GOING TO ACTUALLY DEEPEN THE DEBT PASSIVE SPACE? THE SEGREGATION OF CATEGORIES AND THE LIMITS ON SECURITIES BELOW AA AS WELL AS THE DEFLECTION LIMIT, ARE THESE RULES GOING TO MAKE THE DEBT PASSIVE SPACE LUCRATIVE COMPARED TO ACTIVE FUNDS?

Debt passives are inherently very transparent. What this circular does is that it brings a lot of regulation and risk mitigation in the debt passive space. Now there are limits on sectoral allocation at 25%, group level exposure level at 25%, and issuer level limits like AAA, AA etc. All these norms will mitigate risk in the passive debt funds. The kind of debt passive funds we are seeing now like Bharat Bond. It is a pure AAA passive corporate bond fund. There nothing changes. However, with the space widening with time, there was a need for some checks in the portfolios. If fund houses want to launch a AA passive fund, there is a lot of clarity and set rules for such schemes now.

There is another regulation around tracking difference which has been set at a tolerance level of 1.25%. So, on one side there is leeway on how the index fund or ETF wants to replicate the index, it should not go haywire. It should stay in line with the index performance. There are other regulations about deviation bands that also promote more research by the fund house rather than having a blanket band of 1 or 2%. So, vis-a-vis the active funds, these schemes have a cost advantage and also clear visibility of the portfolio.

I THINK THE MOST EXCITING DECISION THAT CAME IN THIS CIRCULAR WAS THE CLEARANCE TO THE PASSIVE ELSS, BUT IT CAME WITH A CAVEAT. DO YOU SEE FUND HOUSES JOINING THE PARTY SOON OR MISSING IT BECAUSE ALMOST ALL FUND HOUSES ALREADY HAVE AN ACTIVE ELSS?

The caveat comes through a government notice that puts a limit of one ELSS per AMC. That regulation needs to be changed. Apart from that, I believe that given a choice, AMCs will launch one more passive ELSS. But that won't be possible at the moment. However, for the newer players in the market, there is a choice to either go passive or active with their ELSS offering. There is definitely a demand for passive ELSS because we do get feedback from our investors that there should be a passive ELSS also. This was a long-pending ask from the industry.

DO YOU THINK A PASSIVE ELSS WILL BE A GOOD PRODUCT FOR INVESTORS IN A MARKET LIKE OURS?

Yes, definitely. I think it is a very good product. We have to understand that there are various needs of investors and it doesn’t always boil down to cost. A lot of investors want to invest in ELSS to save on taxes but they don’t want to make the choice among funds. Which one to buy? How to track? The investors who want to keep it simple for the long term can totally go for a passive ELSS.