Sebi eases investment rule for passive funds: What this means for you

SebI has increased the group/sponsor level exposure limit for passive funds from 25% to 35%.

Traditionally, all mutual funds, including passive funds, were restricted from investing more than 25 per cent  of their assets in companies belonging to the same group as the fund manager (called the sponsor group). This rule aimed to prevent conflicts of interest and ensure diversification within mutual funds.

However, this 25% limit posed a problem for passive funds:

Passive funds, unlike actively managed funds, track a specific index. Their goal is to mirror the performance of that index as closely as possible. Some sectoral or thematic indexes (focusing on specific sectors or themes) might have a high weighting (importance) for companies within the sponsor group. This weighting could exceed the 25 per cent limit imposed on traditional mutual funds.

 

As a result, passive funds were often unable to perfectly replicate the target index, potentially leading to tracking errors and a slight underperformance compared to the benchmark.

For example, ABC Nifty 50 Index Fund cannot invest more than 25% of its NAV in ABC Bank and ABC Life Insurance despite the fact that Nifty 50 has 30% weightage in ABC Bank and ABC Life Insurance.

Sebi said, “This restricts the passive funds to effectively replicate the underlying index, in cases where group companies of sponsor comprise more than 25% in the index. This also puts such AMCs to a relative disadvantage as compared to other AMCs who may not have a sponsor group company(ies) comprising more than 25% in the underlying index.”

Sebi now has a solution:

In a move to improve the efficiency and competitiveness of passive funds in India, Sebi has increased the investment limit for passive funds in sponsor group companies. Here's the key change:

Increased investment limit: Sebi has raised the investment limit for Index Funds and ETFs in companies belonging to the sponsor group from 25% to 35% of their total assets.

What this means for investors:

Accurate tracking: With this increased flexibility, passive funds can now invest closer to the weightage of sponsor group companies within their target index. This leads to a more accurate reflection of the index's performance in the fund.

Enhanced efficiency: Passive funds can now function more efficiently by staying true to their mandate of tracking the chosen index.

Wider investment options: This change could potentially lead to the development of new Index Funds and ETFs that track more specialized indexes with higher weightage for specific sectors or themes.

It's crucial to remember that even with the relaxed limit, passive funds still operate under overall investment restrictions. These include limitations on holdings in a single company and total exposure to companies beyond the sponsor group.