Increasing efficiency

Lower compliance will help expand the reach of passive funds

The Securities and Exchange Board of India’s (Sebi’s) proposal to lighten the compliance load for asset management companies (AMCs) offering only passive mutual funds and exchange-traded funds (ETFs) is a practical decision and potentially a game changer in terms of expanding the field for this class of instruments. Sebi has said the so-called new “MF Lite” regulations will be introduced this financial year and these will reduce the compliance burden on the purveyors of passive instruments to around a tenth of current levels. There is an important regulatory distinction compared to AMCs offering active diversified schemes. Active funds need to be very tightly regulated since they are open to many types of abuse. But there is much less room for the managers of a passive fund to misuse their positions. A passive fund or ETF mimics some benchmark. It may track an equity index, or a commodity like gold or silver, or government treasury instruments, or it may be a fund of funds (holding a basket of equity funds).
 

There is little or no discretion for the managers: Their mandate is to track the underlying asset closely with as little deviation or “tracking error” as possible, compared to the underlying asset’s returns. The other major criterion is that the expense ratio must be low. Most index instruments tend to have expense ratios of around 20 basis points. There is no room for front-running or insider trading. The regulations for such instruments can, therefore, be simple and designed to ensure they stick to their mandate and don’t indulge in outright fraud.
 

Passive instruments have seen a surge in interest over the past few years in India, but their penetration is still low compared to advanced economies. ETFs and index funds have seen a 340 per cent rise in assets under management (AUM) over the past three years. But the aggregate AUM of index funds is worth about Rs 6.72 trillion, which is around 17 per cent of the total. Despite rapid growth, the absolute size and penetration are low. In the US, for instance, around 43 per cent of the total AUM is in passive instruments; it’s over 60 per cent in Japan, and around 25 per cent in larger EU markets. There are several reasons for a long-term investor to go passive. Index instruments are cheaper. Broad equity indices beat every other conventional asset class (such as debt, real estate) in long-term returns. So an investor has an assurance of acceptable long-term returns. Besides, very few active funds consistently outperform benchmark indices in equities, or debt. Indeed, the efficient market hypothesis suggests that it is impossible for an active trader to consistently outperform in a “perfect market”, one where information reaches everyone simultaneously, and everybody can trade equally quickly and efficiently.
 

While no market is perfect, the more efficient a market is, the harder it becomes to beat the indices. It can be seen in the developed world with high standards of regulatory disclosure. Even in India, which is less efficient, very few active funds consistently beat their respective benchmarks. The regulator has already eased the criteria for entry of new players into the mutual fund industry. If it reduces the compliance burden for AMCs handling passive instruments, there could be more competition and innovation in this sphere.