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Business News/ Money / Personal Finance/  Should you invest in debt ETFs, index funds post Sebi norms?

Should you invest in debt ETFs, index funds post Sebi norms?

Look at the ETF’s mandate, AMC’s track record and whether an active fund will serve your goal better
  • Sebi norms on debt ETFs and index funds are extremely broad in the extent of risk allowed to be taken
  • Graphic: Naveen Kumar Saini/MintPremium
    Graphic: Naveen Kumar Saini/Mint

    Last week, the Securities and Exchange Board of India (Sebi) notified norms for debt exchange-traded funds (ETFs) and index funds. An ETF or index fund passively invests in securities in the same proportion as its target index. A newspaper report suggests that Sebi has laid the framework required for the issuance of a PSU bond ETF (called Bharat Bond ETF) with maturities of 10 and three years. But will the new norms affect other existing and future investors in debt ETFs and index funds? Let’s find out.

    Rules for new MFs

    According to Sebi, the indices for debt funds or ETFs should have a minimum of eight issuers. It has capped the exposure of ETFs to a single issuer to 15%. The issuer’s rating shall be investment grade and above (BBB and above). In case of a downgrade below investment grade or the rating mandated by the index, the ETF must rebalance its portfolio within five days. For active funds, exposure to a single issuer is capped at 10% of the corpus and to a single group at 20%. The two limits can be increased to 12% and 25%, respectively, with the approval of the board of trustees and board of directors of the AMC.

    Also, a debt ETF or index fund shall replicate the index totally. If a specific debt paper in the index is not available, the fund can pick another paper by the same issuer, but the maximum deviation shall be within 10% of the weighted average duration of the securities in the index. At the portfolio level, the ETF can’t deviate from the duration of the index by more than 5%. If meeting these conditions is not possible, the fund can purchase papers of issuers outside the index, up to 20% of the corpus. But such issuers must have a credit rating, duration and yield in line with the paper that is not available. Debt ETFs and index funds need to rebalance their portfolios at the end of every quarter of the calendar year to comply with the norms.

    Rules for existing MFs

    Existing funds need to comply with the rules within three months from the date of the Sebi circular.

    A number of existing debt ETFs, such as Nippon India ETF Liquid Bees, ICICI Prudential Liquid ETF and DSP Liquid ETF, are similar to liquid funds, except that they are available for sale and purchase on stock exchanges. However, the circular excludes ETFs that invest solely in government securities, treasury bills and tri-party repos and, hence, existing liquid ETFs may not be affected.

    Existing gilt ETFs (which invest in government bonds), such as SBI ETF 10-year Gilt, however, are likely to come within the ambit of the Sebi circular.

    It may be noted that debt ETFs have underperformed their actively-managed counterparts over various periods. For instance, Nippon India ETF Liquid Bees, which has a lion’s share of the liquid ETF assets under management (AUM), has delivered a five-year compounded annual growth rate (CAGR) of 5.47% compared to the average of 7.14% CAGR by the actively managed liquid category, according to data from Value Research. Similarly, SBI ETF 10-year Gilt has delivered 4.78% CAGR over the past three years, compared to 7.55% delivered by the debt 10-year constant maturity category, as per Value Research.

    Mint Take

    Sebi norms are seen as being issued to facilitate the upcoming Bharat Bond ETF, which will consist primarily of PSU debt. This will present a direct challenge to actively-managed PSU and bank debt funds (read more at “PSU and banking debt funds can invest up to 20% of their assets in non PSU or banking debt. Also, many of these funds do not have a roll-down strategy, leaving you exposed to interest rate risk," said Radhika Gupta, chief executive officer, Edelweiss Asset Management Co. A roll-down strategy reduces the maturity of the fund as time passes, minimizing interest rate risk. While the proposed Bharat Bond ETF is likely to have a roll-down strategy, other debt ETFs or index funds launched as per Sebi norms may not have it.

    Other experts have questioned the efficacy of a PSU bond ETF. “It is a question mark what happens if a PSU issuer included in the ETF is privatized," said Arvind Chari, head, fixed income and alternatives, Quantum Advisors Pvt. Ltd.

    The Sebi norms are extremely broad in the extent of risk allowed to be taken. For instance, there is no sector limit like the 20% cap for actively managed debt funds. Similarly, there is no restriction on the type of debt that can be bought (for example, credit enhanced debt).

    Different rules for active and passive debt funds is likely to create loopholes for risk taking and confuse investors. “The main benefit of debt ETFs and index funds is their lower expense ratio," said Amol Joshi, founder, Plan Rupee Investment Services. “The risk involved will depend on the mandate of the ETF. For instance, a government bond ETF will have lower risk than an actively managed corporate bond fund, but not necessarily compared to an active government bond fund," he added. “The only restriction is for securities below investment grade so there is no reason for debt ETFs and index funds to have lower risk," said Suresh Sagdopan, founder, Ladder7 Financial Advisories.

    Ensuring liquidity on stock exchanges for the ETF is the biggest challenge, said Dwijendra Srivastava, head, fixed income, Sundaram Mutual Fund. Small investors tend to buy and sell ETFs on exchanges rather than directly from the issuer (which typically involves a large ticket size).“Further, Sebi has given a cure period of five days if the credit rating of a security falls below investment grade. However, in such situations, liquidity tends to dry up. The only possible solution is for the manager to take the affected bonds on its own books," he added.

    Akash Jain, director, S&P Dow Jones Indices, laid out two criteria why investors should prefer passive funds even in the debt space. “Cost and performance consistency are two of the main reasons why investors would look to allocate assets in debt ETFs or index funds," he said, referring to large-scale underperformance of actively managed debt funds, as shown in the S&P Dow Jones SPIVA Report.

    However, it is unclear whether the lower cost of passive investing outweighs the benefits of active management in certain debt categories. “I don’t see debt ETFs or index funds in categories like credit risk where there isn’t a lot of liquidity. However, internationally, there are ETFs in such categories. This is because the ETF as a traded instrument is liquid even if its underlying paper isn’t. So we will have to see how the scenario develops," said R. Sivakumar, head, fixed income, Axis Mutual Fund.

    A person with knowledge of the matter, who spoke on the condition of anonymity, said the proposed Bharat Bond ETF would also be offered in the format of index funds or fund-of-funds, enabling investors without demat accounts to invest in it.

    Individual ETF or index providers can specify additional safeguards, over and above the Sebi rules. Investors should consider aspects such as the ETF mandate (what type of paper it can invest in), the AMC’s track record and whether the objective would be better served with an active fund. In case of any doubt, seek the help of a financial adviser.

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    Neil Borate
    I head the personal finance team at Mint. I have been writing about personal finance for the past 8 years after finishing two degrees in law and economics respectively. I do what I do, to help the ordinary Indian saver and investor.
    Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
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    Published: 04 Dec 2019, 05:15 AM IST
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