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Coming soon: A Passive (Index) ELSS Fund


You want to invest in an ELSS fund for tax-saving, but you prefer only a passive (index) fund. Currently, there are no passive ELSS schemes. This may change now. In a recent circular on Development of passive funds, SEBI has provided a nudge to AMCs to launch a passive ELSS product.

Note that there is no restriction on launching a passive ELSS product even now but no AMC has launched a passive ELSS fund yet.

Multiple reasons for this.

Firstly, AMC charge higher expense ratios on active funds. Well, they can charge higher expense ratios on index funds too, but it is difficult to justify the high cost in an index fund.

With index funds (passive products), it is also easy to do an apple-to-apple comparison. If your Nifty index fund returns 10% in the past 12 months and your friend’s Nifty index fund returns 11%, you will ask questions. After all, the underlying portfolios are the same, the higher tracking difference in the Nifty index fund is either a function of higher cost or the inability to track the index properly.

The gibberish that AMCs and advisors/distributors (including me) can throw at investors to explain underperformance in case of active funds will not suffice for passive funds (index funds).

Secondly, ELSS funds are easy to sell because of tax benefits and it is captive money for 3 years. Active funds mean higher income.

In the aforementioned circular, SEBI makes a specific mention about passive ELSS funds and adds it as one of the fund categories. Now, there can be two types of ELSS schemes. Active ELSS scheme and Passive ELSS Scheme.

SEBI has put restrictions

An AMC can have only 1 ELSS fund. Either an active ELSS scheme or a passive ELSS scheme.

Not both.

Since most AMCs already have actively managed tax-saving funds, do not expect passive ELSS offering from AMCs that already have ELSS funds. As I understand, it is possible to change the nature of an existing scheme from active to passive. However, I am not sure the AMCs will take that path (for the reasons shared above). Such a change will also be unfair to existing investors.

Don’t lose hope yet

However, there are new AMCs such as Navi that have not launched ELSS schemes yet. Besides, many entities have applied for AMC license. A passive ELSS offering can make their new launch stand out. Therefore, you can expect a passive ELSS fund soon.

Which index will the passive ELSS track?

I am not completely sure here.

SEBI Circular states the following:

“The passive ELSS scheme shall be based on one of the indices comprising of equity shares from top 250 companies in terms of market capitalization.” (“SEBI Circular on Development of Passive Funds”)

As I understand, any index whose universe of stocks is limited to top 250 stocks in terms of market cap should quality. Nifty 50, Nifty Next 50, Nifty 100, Nifty 200 and Nifty LargeMidcap 250 are eligible. Similar indices from S&P BSE would be eligible too.

Many factor indices should qualify too. There is no mention that the index should be a market-cap based index.

Small cap indices are not eligible.

A Nifty 50 or a Nifty 100 index fund is a good choice.

Additional Important Announcements in the circular

#1 NAV of Fund-of-Funds (FoFs)

The closing price (and not NAV) of the ETFs shall be used to calculate NAV of FoFs. This is interesting. From what I have seen, at least a few FoFs use NAV of ETF to calculate NAV (Bharat Bond FoFs do this currently. Motilal Oswal Nasdaq 100 FoF seems to be doing this lately, but I need to check this). We will have to see how this plays out or if there is an alternate interpretation.

#2 Disclosure of iNAV for ETFs

Since the price of the underlying constituents of an ETFs keep changing during the day, the NAV of the ETF keeps changing during the trading hours too. As a buyer or seller, you need to be aware of the real-time NAV (iNAV) of ETF so that you can place your buy-sell bid accordingly. AMCs disclose the iNAV (real time NAV) on their website. However, not all AMCs are so forthcoming. As per the new rules, the iNAV of the ETF shall be disclosed on the exchanges in the following manner.

  1. For Equity ETFs: with a maximum time lag of 15 seconds
  2. For Debt ETFs: At least 4 times a day. Opening and closing iNAV and two more with the minimum difference of 90 minutes between the two disclosures
  3. Gold/Silver ETFs: Can be static or dynamic depending upon availability of underlying price
  4. International ETFs: Can be static or dynamic depending upon the intersection of trading hours between domestic and overseas markets.

#3 Disclosure about Tracking Error and Tracking Difference

  1. Tracking error is the annualized standard deviation of the difference in daily returns between the NAV of index/ETF and the benchmark index. Tracking error (except for debt index funds/ETFs) based on past one year rolling data shall not exceed 2%.
  2. Tracking error, based on past 1 year rolling data, must be disclosed daily on AMFI and AMC websites.
  3. Tracking difference is the annualized difference of daily returns between the benchmark index and the ETF/index fund NAV.
  4. Tracking difference shall on disclosed on a monthly basis for various tenures: 1,3,5 and 10 year and since inception.
  5. For debt ETFs/index funds, the average annual tracking difference over the past 12 months shall not exceed 1.25%.

#4 Market making

The circular also speaks about market making in ETFs and the obligations of the AMCs and the market markers. Most ETFs (beyond Nifty 50 ETFs) have wide Price-NAV difference and this may discourage investors from investing in ETFs. Market makers look out for arbitrage opportunities and provide two-way (bid and ask) quotes for ETFs. This ensures liquidity for investors and reduces bid-ask spreads. More importantly, the active participation reduces the difference between the NAV and price of the ETF. We will see if this changes anything.

Overall, a positive development for investors.

Additional Links

SEBI Circular on Development of Passive Funds

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