New Sebi norms limit risk in passive funds, but higher costs anticipated

The purpose of the new rules is to ensure that passive funds remain adequately diversified

The Securities and Exchange Board of India (Sebi) has issued new rules that limit the amount of concentration risk that passive funds (index funds and exchange-traded funds or ETFs) can take. Such norms already exist for active funds, such as exposure to stock cannot exceed 10 per cent. 
 

The Sebi circular contains five key stipulations. No index should have fewer than 10 stocks. The weight of a single stock should not exceed 25 per cent of the portfolio in a diversified (non-sectoral/non-thematic) index, and it should not exceed 35 per cent in case of a sectoral/thematic index. The weight of the top three constituents of the index should, together, not exceed 65 per cent. There are also a couple of rules aimed at keeping illiquid stocks out. Sebi has mandated that stocks included in indices should have a trading frequency of 80 per cent or more (that is, the stock should have traded on 80 per cent or more of the total number of trading days), and its impact cost should have been 1 per cent or less over the past six months. (When a fund invests in a less liquid stock, its buying drives the stock's price up, raising the average cost of purchase for the fund. Similarly, when it sells, its selling drives the price of a less liquid stock down, thereby reducing average sale price. This extra cost that a fund bears when buying or selling illiquid stocks is called impact cost.)    

       

Some sectoral/thematic ETFs will need to rejig their portfolios to comply with these norms. PSU Bank ETFs such as those from Kotak and Reliance have an exposure of slightly above 71 per cent in State Bank of India. They will have to pare their exposure to 35 per cent. Similarly, in the Kotak Banking ETF, the exposure to HDFC Bank stands at 36.19 per cent, so it will have to be pared marginally (numbers are from December-end portfolios).   

The purpose of the circular is to ensure that passive funds remain adequately diversified. "If the exposure to one stock is very high, such a portfolio is not diversified. The out- or under-performance of such an ETF or index fund will depend entirely on that one stock. This defeats the purpose of investing in a fund, which is to get diversified exposure," says Anil Ghelani, senior vice-president, and head of Passive Investments, DSP Investment Managers. Now that there are clear-cut guidelines, it will be easier for index providers to manufacture the right indices, and for fund houses to get approvals for their new launches. 

These guidelines will also ensure that passive funds steer clear of illiquid stocks. Sebi may be taking pre-emptive steps to ensure that risky ideas don't get launched. "In future, a fund house may want to launch an ETF based on micro-cap stocks. When markets crash, liquidity in such stocks vanishes completely. These guidelines will prevent the launch of passive funds that take concentrated exposure to illiquid counters," says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.     

However, complying with these new norms will entail some difficulty. Fund houses will have to comply with these norms at the end of every calendar quarter. Currently, index providers rejig their indices every six months. More frequent rejigging will also mean higher churn and hence higher costs.      

These norms will protect investor interest over the longer term. Nikhil Banerjee, co-founder, Mintwalk said: "Taking concentrated bets can result in better returns, but this is, by no means, assured. By taking more diversified bets, investors can avoid higher downside risk."