SEBI recently issued a circular to revisit the scheme underlying the index of Exchange Traded Funds (ETFs) and Index funds. These
funds are passive mutual funds which replicate the stock composition of a given index.
The guidelines aim to mitigate portfolio concentration risks involved in equity investing. Concentration risks arise when a portfolio contains fewer stocks; this increases the probability of extreme fund value fluctuation and related losses during market volatility.
Under the new norms, Index Funds/ETFs need to follow a relatively broad-based index which is composed of at least 10 stocks. Each stock should have a trading frequency of 80% and an average impact cost of at most 1% over the last six months.
Sector and thematic funds have also fallen in the purview. These are high-risk mutual funds which take concentrated equity bets as per its theme.
In the case of sector and thematic index, the weight of a single stock cannot be more than 35% of the index. For other indices, this limit has been fixed at 25%.
The regulator said that the cumulative weight of the top three stocks could not exceed 65% of the index. SEBI added that all those ETFs/Index funds aiming to replicate a given index would have to comply with these norms.
The funds have to ensure such compliance at the end of every quarter of the calendar year. Also, their website should display the updated components of the indices at all points of time.
All the existing ETFs and Index funds get 3 months to fall in line with the new guidelines. New funds are required to furnish compliance to SEBI before being launched.