Why is it in the news?

• On September 30, the Securities and Exchange Board of India (SEBI) introduced the liberalised Mutual Funds Lite (MF Lite) framework specifically for passively managed schemes.
• This new framework aims to encourage the entry of new players into the mutual fund ecosystem, offer diversified investment opportunities for retail investors through less risky schemes, and enhance market liquidity.

Rationale for a Separate Framework

• Passively managed mutual fund schemes are generally perceived as less risky than actively managed funds. They typically track a benchmark index, such as the BSE Sensex or Nifty50, aiming to replicate its performance.
• Because the constituents of these benchmark indices are publicly available, the risks associated with passively managed schemes are comparatively lower.
• SEBI noted that the investment strategy of passive funds involves mimicking instruments that already follow established rules, giving asset management companies (AMCs) “negligible discretion” regarding asset allocation and investment objectives.
• Therefore, the existing framework, designed primarily for active mutual fund operators, was deemed unsuitable for passively managed schemes, prompting the introduction of the relaxed framework.

Encouraging New Market Players

• The new framework is expected to facilitate the entry of new players by relaxing governance structures and net worth requirements.
• SEBI has set a minimum net worth of ₹35 crore for AMCs operating passive funds, which is seen as a reasonable threshold.
• By emphasizing the need for liquid assets, the regulator acknowledged that funds might require the entirety of their net worth to be deployed in liquid assets continuously.
• This lower minimum requirement aims to provide a competitive edge and encourage a cost-effective passive mutual fund industry. According to stockbroking firm AngelOne, these changes are likely to attract both existing and new market participants.

Governance Changes

• Regarding governance, SEBI recognized that the oversight responsibilities of trustees—who are tasked with protecting investors’ interests—are significantly diminished in the management of passive funds. As a result, the framework allows for certain relaxations in governance.
• However, it maintains that trustees must still address conflicts of interest, oversee related party transactions, and prevent misconduct, including market abuse.
• Additionally, while the AMC board will take on more operational oversight, they are still required to ensure fairness in fees and expenses and to maintain tracking error within regulatory limits.

Risk Management and Disclosures

• The success of a passively managed scheme hinges on two main factors: Total Expense Ratio (TER) and tracking error. The new framework moves away from traditional metrics like strategy and investment avenues, which will no longer be included in the scheme information document (SID) for prospective investors.
• SEBI insists that investors should still be informed about the underlying benchmark’s name and other essential details in the SID.
• Furthermore, the responsibilities of risk management committees, previously essential in the context of active funds, can now be managed by the AMC’s audit committee due to the reduced risks associated with passive management.

Conclusion

• SEBI’s introduction of the MF Lite framework aims to modernize and simplify the regulatory environment for passive mutual funds, making it more accessible for new entrants while still ensuring essential investor protections and governance measures are in place.