SEBI’s Mutual Funds Lite Framework: A Regulatory Inflection Point For Passive Funds In India

Introduction

The capital markets regulator, Securities and Exchange Board of India (“SEBI”), released a consultation paper in July 2024 (“Consultation Paper”), seeking public comments on the much awaited liberalised mutual funds (“MF”) framework, designed specifically to govern and streamline operations for passive funds like index funds and exchange-traded funds (“ETFs”) (the “MF Lite Framework”.)[1]

In its meeting of the board held on September 30, 2024, SEBI approved the introduction of the MF Lite Framework.[2] Subsequent to the perusal of the public comments to the Consultation Paper and deliberations by SEBI’s Mutual Funds Advisory Committee (MFAC), on December 16, 2024, SEBI notified the SEBI (Mutual Funds) (Third Amendment) Regulations, 2024 (“MF Regulations Amendment”), to incorporate the operative provisions on the MF Lite Framework.[3] In addition, SEBI notified the streamlined provisions of the MF Lite Framework by way of a circular dated December 31, 2024 (“MF Lite Framework Circular”). Based on our analysis of the MF Regulations Amendment and the MF Lite Framework Circular, we highlight in this blog the requirement for carving out a separate framework in the MF segment, the salient features of the MF Lite Framework, and the possible resultant industry impacts and/or concerns.

Passive Funds and the need for carving out a separate framework

Mutual funds are broadly categorised into “actively managed” and “passively managed” schemes. Actively managed funds depend on the expertise of fund managers or asset management companies (“AMCs”), who define investment philosophy and select securities, whereas passively managed funds (e.g., index funds, ETFs, and Fund of Funds (“FoFs”) investing in ETFs) aim to replicate the performance of a specific market index and/or sector and their underlying indices, such as NIFTY50 or SENSEX. While active mutual funds need fund managers to actively monitor the selected securities, portfolios of index funds can be easily tracked, which makes passive funds more transparent with minimal human intervention, simpler to invest in, and more cost effective. Passively managed funds have become increasingly popular in recent years, with assets under management (“AUM”) for passive funds surpassing INR 10 lakh crore (as of June 2024).[4] This represents a significant 17 per cent of the total MF market share with potential for greater growth in the coming years.[5]

Presently, all MFs in India are governed by the SEBI (Mutual Funds) Regulations, 1996 (“MF Regulations 1996”). The proliferation in passive fund investments can be attributed partly to the need for carving out tailored regulations that address the unique characteristics of such funds. Further, the MF Regulations 1996 cater to the complexities and risks associated with actively managed funds, adopting a stringent regulatory approach;  however, passive funds require a more dynamic and relaxed approach, as has been identified by SEBI in the Consultation Paper.

The creation of a separate framework with lower entry barriers will also aid financial inclusion, expanding the scope of India’s investment ecosystem for both amateur and seasoned investors. The introduction of the MF Lite Framework is likely to simplify market entry, encourage participation from new players in the MF segment, reduce regulatory hurdles, increase market penetration, and promote competition. An increase in competition in the industry with the entry of new players is expected to boost innovation, diversify investments options for retail investors, and improve liquidity in the market.

Salient features of the MF Lite Framework

The MF Lite Framework seeks to relax the regulatory requirements, primarily for MF operators and market products – (i) entities intending to register and operate in the MF Lite segment (sponsors, trustees, AMCs) (“MF Operators”); and (ii) existing passive fund schemes as well as those that may be launched in the future (“MF Products”). The MF Regulations Amendment introduces a new Chapter XI in the MF Regulations 1996 incorporating the MF Lite Framework.

Key Changes – MF Operators

    The following are the key changes introduced by way of the MF Lite Framework in relation to the MF Operators:

    Eligibility criteria for a sponsor and transactions through associated broker

      The MF Lite Framework sets out lower net worth and profit requirements for sponsors and fund houses wishing to launch passive-only funds as follows:

      • Main eligibility route
        • The sponsor should have a positive net worth in the previous five (5) years
        • The positive liquid net worth of the sponsor should be more than the proposed capital contribution of the sponsor in the AMC.
        • The sponsor should also have a net profit after tax (“PAT”) in three (3) of the preceding five (5) years, including average profit in the last five (5) years to be at least INR 5 crore (present requirement is INR 10 crore);
        • The minimum net worth for AMCs with a “sound track record” (criteria set out in Regulation 81 of MF Regulations 1996) shall be INR 35 crore, which can be relaxed to INR 25 crore if it has registered profits for five (5) successive years.
        • in case of change in control (“CoC”) of the existing AMC due to acquisition of shares, the positive liquid net worth of the sponsor or funds tied up by the sponsor, shall be to the extent of aggregate par value or market value of the shares proposed to be acquired, whichever is higher.
      • Alternate eligibility route (for sponsors not satisfying the “sound track record” criteria)
        • The alternate eligibility route for a sponsor is by capitalising the AMC such that it has a minimum net worth of INR 75 crore (present requirement is INR 150 crore). In such a case, the initial shareholding of the sponsor shall be locked in for a period of three (3) years, down from the present requirement of five (5) years (the lock-in shall also be applicable in the case of CoC of the AMC due to acquisition of shares).
        • The AMC to be eligible for capitalisation by the sponsor shall have a minimum net worth of INR 50 crore, which can be relaxed to INR 25 crore if it has registered profits for five (5) successive years (all of which must be deployed in liquid assets).

      Under both eligibility routes, the sponsor shall be responsible for the maintenance of minimum positive liquid net worth of the AMC and shall hold a minimum 40 per cent of the AMC’s net worth.

      Furthermore, AMCs would be allowed to conduct up to 10 per cent of transactions through associated brokers, which is an increase from the previous maximum of 5 per cent, which for non-associated brokers shall be up to 25 per cent (thresholds to be applied for a block of any three months).

      Shareholding and governance in MFs

      The MF Lite Framework incorporates greater trustee responsibilities, oversight mechanisms, robust governance while ensuing flexible compliance requirements.

      • Since the current law does not demarcate between actively and passively managed schemes, several MFs manage both the schemes under their existing registration. Such funds shall hive off their passive fund schemes either to a separate AMC (as a group entity) under a common sponsor or to an unrelated entity and continue to manage only the active schemes (post hive off). If the MF does not undertake this segregation, the MF Lite Framework will apply only to the passive scheme it manages.
      • In such cases, the sponsor shall be required to completely segregate and ring-fence its resources including infrastructure, technology, and staff for the two separate AMCs. Regulatory requirements including continuous net worth requirement shall be made separately applicable to both AMCs. (A sponsor shall be permitted to obtain only up to two (2) registrations for such actively and passively managed funds, respectively.) In this regard, the AMC housing the passive schemes shall be allowed to carry the track records of such schemes.
      • The sponsor, and not the trustee, shall appoint the board of directors (“Board”).
      • Certain common responsibilities entrusted upon both trustees and AMCs under the extant MF Regulations 1996 shall be applicable only to the Board of AMCs including:
        • periodic reporting to SEBI;
        • the overall risk management of all schemes, including setting up of a risk management committee (“RMC”);
        • filing of offer documents and obtaining regulatory approvals;valuation of investments in accordance with the specified requirements; and
        • constitution of unit-holders protection committee (UHPC).
      • Considering lower risks associated with passive schemes, especially, market risks and investment risks, it shall not be mandatory for MF Lite AMCs to constitute RMCs and their role shall be undertaken by the audit committees.
      • AMCs registered under the MF Lite Framework shall not be allowed to do any business activity other than managing passive MF schemes. (Currently, MF Regulations 1996 allow AMCs to conduct business activities other than in the nature of management and advisory services, provided not in conflict with the activities of the MF.)

      Revised framework for Trustees

      The MF Lite Framework entrusts trustees with core responsibilities and protecting unitholder interests than general management of the fund.

      • The appointment of a trustee in more than one MF shall be permitted, including in separate funds of the same sponsor, as long the trustee is an independent entity and not an associate of the sponsor or the AMC of the concerned MF. (Presently, MF Regulations 1996 restricts the appointment of a trustee in more than one MF.)
      • The present requirement of a sponsor or a shareholder not being allowed to hold 10 per cent or more shareholding in more than one trustee/AMC shall be dispensed with.
      • Trustees under the MF Lite Framework shall not be mandated to constitute audit committees or RMCs.
      • The prior consent of the trustee shall be required in case of CoC of an AMC.
      • Submission of half-yearly trustee reports (HYTR) by trustees to SEBI shall be discontinued considering the limited role of trustees in case of MF Lite (as required under the MF Regulations 1996); only the AMCs shall be required to submit a yearly AMC report (YAR) to SEBI.
      • Association of Mutual Funds in India (“AMFI”) shall, in consultation with SEBI, prescribe a standard trust deed (currently specified in Schedule 3 of MF Regulations 1996) and the investment management agreement to be entered into between the trustees and AMCs.

      However, critical areas (e.g., related party transactions, conflicts of interest, undue influence by sponsors, and misconduct, including market abuse and misuse of information for trustees) will continue to be under the purview of the extant MF Regulations 1996.

      Simplified scheme information document (“SID”) and key information memorandum (“KIM”)

      The MF Lite Framework aims to further simplify and streamline the SID, a document that provides investors with comprehensive information about a mutual fund scheme (building on the SEBI Circular from November 1, 2023[6]).

      • The MF Lite Framework fast tracks all SIDs for passive MF schemes. The current registration process of a domestic passive MF scheme requires the submission of the SID with the SEBI, which approves the SID by way of either: (i) normal registration; or (ii) fast track registration granted based on an undertaking by the CEO of the AMC taking responsibility for acts of omission or commission.
      • It has omitted some parameters from the SID, including investment strategy, instruments in which schemes may invest, and scheme benchmark performance because the low risks in passive schemes.
      • It has, however, included in the SID other relevant parameters, such as tracking error, tracking difference, and the name of the underlying benchmark. It mandates updating the SIDs for passive schemes only once, within two (2) months from the end of the financial year. (The current MF Regulations 1996 mandate updating SIDs within six (6) months after the end of the first and second half of the fiscal year in which the schemes were launched, using the relevant data and information as of the end of the previous month.)
      • The MF Lite Framework relaxes the requirement for a separate KIM filing, enhancing the efficiency and accessibility of essential information for investors.

      Key Changes – MF Products

      The following are the key features introduced by way of the MF Lite Framework in relation to the MF Products:

      Introduction of hybrid ETFs/Index funds

      The MF Lite Framework seeks to establish hybrid passive funds, so that investors can invest in a single product that is exposed to both equity and debt securities, which will give them with more flexibility and diversification opportunities (a hybrid index combines features of both debt and equity indices). The current regulation allows passive funds to replicate only a debt index or an equity index, with no framework to replicate a hybrid index.

      • The framework for hybrid passive schemes is as under:
      Categories of Hybrid Passive Schemes Asset Allocation of Benchmark Index
      Debt orientedEquity: Debt – 25:75
      Equity orientedEquity: Debt – 75:25
      BalancedEquity: Debt – 50:50
      • Initially, each MF can introduce only one hybrid fund in a particular category.
      • The minimum initial investment for hybrid ETFs/Index funds shall be INR 10 crore.
      • The issuer of the ETF/Index fund must ensure that the asset allocation between equity and debt in all hybrid ETFs/Index funds complies with the MF Lite Framework at the end of each calendar quarter.
      • Sectoral/Thematic funds and Target Maturity Funds cannot be used for the equity and debt components of hybrid passive funds.

      Investments by passive schemes

      Under the MF Lite Framework, passive schemes shall not be allowed to invest in:

      • unlisted debt instruments;
      • bespoke or complex debt products;
      • securities with special features;
      • inter-scheme transactions;
      • short selling;
      • equity derivatives (in case of portfolio rebalancing); and
      • unrated debt and money market instruments (except G-Secs, T-Bills, and other money market instruments)

      Implementation

      The implementation of the MF Lite Framework shall be undertaken in a gradual and phased manner, with the following categories of passive schemes to be covered in Phase 1:

      1. Passive funds based on only domestic equity passive indices (broad indices tracked by passive funds or those that act as primary benchmark for actively managed funds) with collective AUM of INR 5,000 crore and above as on December 31 of each financial year.
      2. Passive funds based on onlyoverseas equity passive indices (broad indices tracked by passive funds or those that act as primary benchmark for actively managed funds) with quantitative threshold/AUM of USD $20 billion and above as on December 31 of each financial year.
      3. All G-Sec/T-bills/SDLs based domestic target maturity debt passive funds and domestic constant duration passive funds based on such debt indices with collective AUM of INR 5,000 crore and above as on December 31 of each financial year.
      4. All Gold ETFs, Silver ETFs, and FoFs based on only Gold or Silver ETFs.
      5. Overseas ETFs and FoFs that have a single underlying overseas passive fund.
      6. All FoFs investing only in single domestic/overseas index.
      7. The indices, on which overseas passive schemes can be launched, shall be standardised across industry and broad based in nature.
      8. Overseas ETFs/Index funds and FoFs investing in overseas ETF/index funds shall comply with the diversification requirement of minimum 10 securities in an equity index portfolio.

      AMFI, in consultation with SEBI, shall prescribe the list of such domestic and overseas equity, and debt indices on a periodic basis.

      Conclusion

      With the introduction of the MF Lite Framework, SEBI aims at bringing simplicity and clarity to the passive MF investment space in India. Although the evolution of the Indian MF industry has benefited both fund houses and investors alike, MF Lite will help further expand the range of low-cost and low-maintenance investment options available for retail investors while rationalising compliance costs for fund houses. Participation from a larger base of retail investors, especially those currently underserved or reluctant to invest due to the perceived complexities in traditional mutual funds, will see a host of new players enter the MF Lite space as well. By granting retail investors access to thematic funds, factor-based funds, and international funds and allowing investors to provide diversified, tailored solutions and niche market offerings, the MF Lite Framework is likely to revolutionise India’s passive funds landscape.

      However, a new product innovation necessitates careful consideration of potential drawbacks and a focus on end consumer protection. Will the introduction of a separate regulation add unnecessary complexity and redundancy as the existing regulations are comprehensive and sufficient to manage both active and passive funds? By focusing solely on passive schemes framework, would investors miss out on the potential benefits of active management strategies? Even with the entry of new players under new regulations, will the offerings largely be homogeneous with similar index-based returns?

      If the true intent of the regulator is to reduce compliance burdens, would it be more effective to streamline regulations across the entire MF industry rather than create a separate category? Only time will tell whether the MF Lite Framework adds to or lessens regulatory conundrums in the MF segment.

      [1] The Consultation Paper can be accessed here: SEBI | Consultation Paper for introduction of Mutual Funds Lite Regulations (MF LITE) for passively managed Mutual Funds Schemes <a href=‘https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes’ target=‘_blank’ style=‘color:#007ffc’> Click here to provide your comments </a>

      [2] Press release to the 207th meeting of the SEBI Board (refer to page 14), accessible at: https://www.sebi.gov.in/media-and-notifications/press-releases/sep-2024/sebi-board-meeting_87154.html

      [3] The SEBI (Mutual Funds) (Third Amendment) Regulations, 2024 can be accessed here: https://www.sebi.gov.in/legal/circulars/dec-2024/introduction-of-a-mutual-funds-lite-mf-lite-framework-for-passively-managed-schemes-of-mutual-funds_90393.html

      [4] https://economictimes.indiatimes.com/mf/mf-news/passive-investing-booms-mutual-funds-cross-rs-10-lakh-crore-aum/articleshow/112687323.cms?from=mdr

      [5] https://www.motilaloswalgroup.com/Media-Room/Press-Release/-/indias-passive-mutual-fund-industry-surpassin/AM/20626

      [6] SEBI circular on ‘Simplification and streamlining of Offer Documents of Mutual Fund Scheme’ dated November 01, 2023 accessible at: https://www.sebi.gov.in/legal/circulars/nov-2023/simplification-and-streamlining-of-offer-documents-of-mutual-fund-schemes_78665.html