SEBI Overlap Rules May Push Mutual Funds Toward Passive Products

Background

The Securities and Exchange Board of India (SEBI) has revised mutual fund categorization norms to ensure clear differentiation between schemes within the same category.

Under the new rules:

• Portfolio overlap between thematic/sectoral funds and other equity schemes is capped at 50%.
• The rule excludes large-cap funds.

The move aims to prevent fund houses from launching multiple funds with similar portfolios under different themes.

What Is Portfolio Overlap?

Portfolio overlap refers to two mutual fund schemes holding many of the same stocks.

Previously:

• Asset management companies (AMCs) could launch several thematic or sectoral funds with similar holdings.

Now:

• SEBI requires meaningful differentiation between schemes.

This makes it harder to run multiple active funds with similar investment universes.

What Are Passive Funds?

Passive funds track a market index instead of actively selecting stocks.

Examples include:

1. Index Funds
2. Exchange-Traded Funds (ETFs)
3. Fund of Funds (FoFs) investing in passive instruments

These funds follow rule-based investment strategies rather than active portfolio management.

Advantages of Passive Funds

Passive funds offer several benefits:

Lower Costs

Since they track an index, they require less active management, leading to lower expense ratios.

Transparency

Investors know exactly which index the fund tracks.

Easier Product Differentiation

Fund houses can launch different index-based products without violating overlap restrictions.

Possible Innovations in Passive Products

Experts expect greater innovation in passive investing due to the new rules.

1. Factor-Based Funds (Smart Beta)

These track indices based on specific factors such as:

• Higher Return on Equity (ROE)
• Strong dividend yield
• Lower volatility
• Better quality metrics

These are called factor-based passive funds.

2. Thematic Index ETFs

New ETFs may focus on emerging sectors such as:

• Electric Vehicles (EVs)
• Clean energy
• Technology sectors

These could track small baskets of 10–20 specialized stocks.

Growth of Passive Funds in India

Passive investments have been growing rapidly in India.

According to the Association of Mutual Funds in India (AMFI):

• Passive AUM share increased from 7.3% five years ago
• To about 19.02% of total mutual fund assets.

Global Comparison

In developed markets, passive investing dominates.

For example:

• In the United States, passive funds account for more than 50% of mutual fund assets.

India may gradually move in the same direction, though growth may be slower.