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LIBERALISED MUTUAL FUNDS (MF LITE)FRAMEWORK

9th October, 2024

Disclaimer: Copyright infringement is not intended.

Context: 

The Securities and Exchange Board of India (SEBI) introduced the liberalised Mutual Funds Lite (MF Lite) framework for passively managed schemes. 

What is the liberalised Mutual Funds Lite (MF Lite) framework by SEBI? 

With the goal of lowering entry barriers and promoting greater participation in the mutual fund industry, the MF lite framework is a streamlined regulatory framework for passively managed mutual fund products like index funds and exchange-traded funds (ETFs).

Purpose Of The Mutual Funds Lite (MF Lite) Framework

Encourage New Players: The framework's goal is to facilitate the entrance of new companies into the mutual fund industry.

Investment Opportunities That Are Less Dangerous: It provides individual investors with a range of investment options that are less dangerous.

Enhance Market Liquidity: The goal of the program is to make the market more liquid by attracting more investments and promoting passive funds. 

Need for a Different Framework

Restricted discretion:

Because asset management companies (AMCs) adhere to benchmark standards, investors  are unaware about how they allocate assets.

Inapplicability of Current Regulations:

The existing regulations, tailored for active funds, were deemed irrelevant for passive schemes, which necessitated a new framework.

Features of the Framework

Relaxed Eligibility Criteria:

The framework does not require fund sponsors to strictly adhere to track record, and profitability to be eligible.

Minimum Net Worth Requirement:

To make it easier for new players to enter the market, AMCs operating passive funds are required to have a minimum net worth of ₹35 crore.

Governance structure of Asset Mangement Companies 

  • Decreased Oversight for Trustees: The trustees in the AMCs Board will have decreased oversight powers.
  • Conflict of Interest Oversight: Trustees will still in charge of avoiding conflicts of interest, keeping an eye on transactions involving related parties, and stopping wrongdoing.
  • Board Responsibilities: The Asset Management Company’s (AMC's) board will be mostly responsible for overseeing day-to-day operations, including tracking errors, managing fees, and spending.

Risk Control and Disclosures:

The two primary elements that determine the performance of passive schemes are the tracking error and the total expense ratio, or TER. They have to be disclosed regularly.

Investor Disclosure:

The Scheme Information Document (SID) of the framework will contain important information such as the name of the underlying benchmark, but it will not concentrate on strategy.

Audit Committee Role:

Because of the AMC's streamlined oversight structure, the audit committee may be tasked with carrying out the responsibilities of the risk management committee.

Tracking error 

It is the difference in actual performance between a position (usually an entire portfolio) and its corresponding benchmark.

One way to interpret the tracking error is as a measure of the level of risk associated with an actively managed fund.

Analyzing a portfolio manager's historical tracking error can reveal information about the potential level of benchmark risk control the manager will exhibit going forward. 

The net asset value (NAV) of an index fund is naturally inclined toward being lower than its benchmark because funds have fees, whereas an index does not. A high expense ratio for a fund can have a significantly negative impact on the fund's performance.

Total Expense Ratio (TER)

The total expense ratio is the measure of the total cost/expenses incurred in managing the fund. 

To operate a mutual fund, a fund house or asset management firm (AMC) must pay a number of fees and charges. Investors in mutual funds are assessed a fee known as the Total Expense Ratio (TER) to cover these costs.

A mutual fund's TER may fluctuate over time. Investors are happier when a fund's TER declines because their returns rise, but when TER rises, they may feel deceived because their returns are reduced.

What are Passive funds?

Passive funds consistently mirror the performance of a market index to maximise returns. A passive fund's portfolio closely mimics a chosen market index, like the Sensex or Nifty, in terms of the percentage and makeup of its investments.

Passive funds function differently from active funds in that the fund manager does not have to actively choose each stock.

Compared to their active counterparts, passive funds are simpler, which makes them easier to monitor and more accessible. Using passive funds allows investors to match their returns to the performance of the market as a whole.

These funds are particularly cost-effective since they don't have to pay for the costs of researching stocks, choosing stocks, or trading assets frequently.

Passive fund types

There are various sorts of passive mutual funds that allow investors to generate money over time. 

Important Passive Funds:

Index funds: Index funds are mutual funds or exchange-traded funds (ETFs) that track a specific market index, such as Sensex or Nifty. They are designed to replicate the performance of the index they track and offer investors broad exposure to a particular segment of the financial market.

Exchange Traded Funds (ETFs): ETFs are a type of passive fund that tracks the performance of an underlying index. An ETF is a portfolio that closely resembles an index. ETFs don’t try to outperform their benchmark indexes. Furthermore, ETFs trade on the stock exchange, and thus one can buy and sell ETFs on the exchange. As a result, the ETF prices fluctuate throughout the day.

Fund of Funds (FOFs): FOFs are mutual funds that invest in other mutual funds. They are designed to provide investors with a diversified portfolio of funds. FOFs can be actively or passively managed.

Smart beta: Smart beta funds are similar to ETFs in many ways. They combine the benefits of passive funds with the selection of active investments based on certain criteria. This allows the fund to generate higher returns using a cost-effective model.

Read the difference between active and passive funds here:Difference Between Active and Passive Funds

Important articles for refrence:

SEBI

Sources:

https://epaper.thehindu.com/ccidist-ws/th/th_international/issues/102606/OPS/G33DE9HUL.1.png?cropFromPage=true

https://www.bajajfinserv.in/investments/passive-investing

PRACTICE QUESTION

Q.Consider the following statements about the Passive funds in the in context of stock markets in India: 

  1. Passive funds actively choose each stock for investing.
  2. Compared to their active counterparts, passive funds are simpler, which makes them easier to monitor and more accessible.
  3. Exchange Traded Funds (ETFs) and Smart beta funds are examples of Passive funds.

How many of the above statements is/are correct?

A.Only one

B.Only two

C. All Three

D.None

Answer: B

Explanation:

Statement 1 is incorrect: 

Passive funds consistently mirror the performance of a market index to maximise returns. A passive fund's portfolio closely mimics a chosen market index, like the Sensex or Nifty, in terms of the percentage and makeup of its investments.

Passive funds function differently from active funds in that the fund manager does not have to actively choose each stock.

Statement 2 is correct: 

Compared to their active counterparts, passive funds are simpler, which makes them easier to monitor and more accessible. Using passive funds allows investors to match their returns to the performance of the market as a whole. 

These funds are particularly cost-effective since they don't have to pay for the costs of researching stocks, choosing stocks, or trading assets frequently.

This cost efficiency contributes to the appeal of passive funds as an uncomplicated and economical investment option.

Statement 3 is correct: 

There are various sorts of passive mutual funds that allow investors to generate money over time. Important Passive Funds:

Index funds: Index funds are mutual funds or exchange-traded funds (ETFs) that track a specific market index, such as Sensex or Nifty. They are designed to replicate the performance of the index they track and offer investors broad exposure to a particular segment of the financial market.

Exchange Traded Funds (ETFs): ETFs are a type of passive fund that tracks the performance of an underlying index. An ETF is a portfolio that closely resembles an index. ETFs don’t try to outperform their benchmark indexes. Furthermore, ETFs trade on the stock exchange, and thus one can buy and sell ETFs on the exchange. As a result, the ETF prices fluctuate throughout the day.

Fund of Funds (FOFs): FOFs are mutual funds that invest in other mutual funds. They are designed to provide investors with a diversified portfolio of funds. FOFs can be actively or passively managed.

Smart beta: Smart beta funds are similar to ETFs in many ways. They combine the benefits of passive funds with the selection of active investments based on certain criteria. This allows the fund to generate higher returns using a cost-effective model.

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