ELSS ETFs: Passive Investing the New Normal

SEBI recently issued regulations for mutual funds to launch Equity-Linked Savings Schemes (ELSS) as passively-managed funds based on an index comprising the top 250 stocks. These regulations will come into effect on 1st July 2022. These regulations were long due and will help enhance market-making, transparency, and liquidity of Exchange Traded Funds (ETFs).

What is a passively managed fund? 
Passive funds track a benchmark index and comprise securities in their benchmark. A passively managed fund provides returns in line with the underlying benchmark and does not require the fund manager to manage the fund actively. Since these funds do not require active management, they attract lower expense ratios and capital gains distribution, making them tax-efficient than regular funds. The importance of passive funds has gained prominence over the years as fund managers increasingly find it difficult to outperform the benchmark, especially in large-cap segments. 

What is an ELSS?
An equity-linked savings scheme (ELSS) is a tax savings scheme in which a fund manager invests 80% of the corpus into listed securities. An investor can avail of a total deduction of 1.5 lakh under section 80-C of the IT act by investing in this scheme. However, there is a lock-in period of 3 years when investment is made through this scheme in which the investor cannot exit their investment.

What do the regulations entail?

Market Making: SEBI, in its circular, has mandated that direct transactions with the Asset Management Companies (AMCs) to redeem or create ETF units cannot be below 25 crores. This move will improve liquidity in the exchanges as more investors will invest through exchanges rather than directly with the AMCs. SEBI has also mandated the appointment of 2 market makers who are members of the stock exchange to ensure liquidity in the exchanges. 
 
Single Offering: SEBI has stipulated that a fund house can launch either an actively managed ELSS or a passive ELSS fund. This is done to restrict the number of ELSS schemes so that only new fund houses that do not have an active ELSS scheme launch it.

Incentive to market makers: AMCs can now pay fees or incentives to the market makers within the stipulated limit of the scheme’s Total Expense Ratio (TER). SEBI has also urged AMFI to ensure that the capital requirement of these market makers is reduced to enhance liquidity. This will encourage more players to become market makers, further improving liquidity in ETFs. Moreover, incentives are linked to the performance of market markets in terms of generating liquidity for the ETFs.

Tracking error limits: Tracking error measures the difference in the fund’s performance compared to its underlying index. SEBI re-iterated the tracking error that a passively-managed fund can have vis-à-vis the underlying index. The tracking error should not be more than 2 percent for equity ETFs based on past year rolling data.

Real-time data: Real-time NAV must be disclosed continuously with a 15-second lag for equity ETFs. Tracking error also has to be disclosed daily. Due to liquidity issues, ETF prices often differ from the fund’s Net Asset Value (NAV). NAV of the fund is equal to the value of the underlying asset of the ETF. While the practice of disclosing ETF NAV continuously throughout the day is already in existence, the current guidelines institutionalize it. 

Investment limit for passive debt funds: For passive debt funds, different limits have been set for different kinds of funds, depending on their composition.
When the index has more than 80% exposure to corporate debt securities, it cannot have more than 15% AAA securities from a single issuer. The limit is 12.5% and 10% for AA-rated and A-rated deposits, respectively.
If the index is a hybrid with G – secs, State Development Loans (SDLs), and corporate debt (up to 80%), the weight for a single issuer’s AAA-rated, AA-rated, and A-rated securities cannot be more than 10%, 8%, and 6% respectively. However, the single issuer limit is 15% for AAA-rated securities of PSUs.
An index can neither have more than 25% exposure to the debt securities of the same business nor more than 25% weightage in the same sector. However, these limits are not applicable for indexes based on G – secs and SDLs.

Why is investing in ETFs becoming more attractive than investing directly in the markets? 

Investing directly in stock markets is risky as it may expose you to stock-specific risks. It may also expose your portfolio to concentration risk which arises when investors invest a sizeable portion of their portfolio in 1- 2 sectors. Also, most investors do not have the necessary skills or time to invest and study the markets.

On the other hand, ETFs offer a well-diversified option of investment that is less risky than investing directly in individual securities. In the current times where beating the index has become extremely challenging without taking on excessive risk, passive funds are becoming popular. This is evident from the rise in no. of ETFs size of AUMs of ETFs as shown in Table-1 and Table-2
 
Why is passive investing more suited to retail investors?
The priority for most retail investors is capital appreciation in the long term at minimum risk. This can be achieved by investing in ETFs, which is an excellent passive investment option. While institutional investors have the expertise in tracking and analyzing the markets, it is difficult for retail investors to do the same. They can, therefore, invest in a well-diversified basket of securities that tracks a particular index through a passive investing option. This will help them in benefiting from the growth in the stock market. 

What must the investors do?

All investors must first understand their investment needs and the product they are investing in. They must select a product based on their long-term needs. It is difficult to beat the market in the current inflationary environment, so the best option is to go for passive investment ELSS schemes. These schemes are beneficial as they have a lower charge than active ELSS schemes as they require more due diligence and hence more fees. The new regulations that the SEBI has issued make investing in these schemes an even more attractive option, as these regulations have cleared a lot of confusion about ETFs and other passive investing products. Also, there has been an increasing trend in passive investment products for a long time now, especially in the large-cap segment.

Disclaimer: This write up is solely for educational purposes.

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