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Sebi Postpones Direct ETF Buying Rule - What It Means For Eligible Investors?

The Securities and Exchange Board of India (Sebi) has extended the deadline for directly buying exchange-traded funds (ETFs) from mutual fund asset management companies (AMCs) by three months to November 1, 2022.

The Securities and Exchange Board of India (Sebi) has extended the deadline for implementing the scheme of direct ETF unit buying with mutual fund AMCs for eligible investors. The direct buying provision will come into effect from November 1, 2022. It was among the many changes that Sebi announced in a circular on May 23, 2022.

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What Problem Did Direct Buying ETF Units At AMCs Solve?

Hitendra Parekh, fund manager of Quantum Nifty 50 ETF and Quantum Nifty 50 ETF Fund of Fund, Quantum AMC, explained that an ETF is an exchange-traded fund hence investors can buy them from stock exchanges the same way they buy a normal share. 

But if an investor wishes to buy/redeem a large number of ETF units, and the stock exchanges do not have the required liquidity, then the investor’s impact cost and bid-ask spread could be higher.

“This is where market makers come into the picture. What market makers essentially do is they provide bid/ask spread at fair value (at Real Time NAV plus/minus his margin) of ETF units so that it does trade at a wide discount/premium to real-time NAV. If they do not provide liquidity in ETF trading, then investors cannot buy/sell ETF units at a fair price," Parekh added.

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What Is This System Not Yet Implemented?

Sebi said that “feedback was received from stakeholders expressing certain challenges with respect to the implementation of the above clause.”

Parekh said that if an investor places a large buy or redeem ETF order on stock exchanges, the investor may “have to pay a higher premium for buy or get a higher discount for sell”. 

He added that in such cases, large investors approach the fund houses as eligible investors and subscribe/redeem ETF units with the AMC like market makers do in unit creation size. This was quite normal before the May 23, 2022 circular. 

According to Sebi circular, “market makers can approach fund houses directly for unit creation/redemption in unit creation size, but other investors can approach fund houses directly only when they want to subscribe/redeem units above Rs 25 crore. This provision has been postponed by Sebi in a circular dated July 28, 2022.

Parekh said that one of the reasons for the delay could be that “large investors may not be getting large quantity at fair price from the market and for a market maker it may be difficult to fulfill the demand of large investor at a low spread, as the framework for the settlement of market maker transaction suggested by above circular is still not implemented.”

Tracking Error

Quantum AMC’s Parekh further explained that “tracking error is the standard deviation of the difference in returns between an ETF and its Benchmark Index. Looking at Tracking Error, investors can judge how closely a fund manager is tracked by its fund’s benchmark. Lower the tracking error, better the fund performance.” 

In essence, tracking error measures the degree of deviation between returns generated by an ETF or fund and its set benchmark.

The Sebi circular mandated that “the tracking error based on past one-year rolling data shall not exceed 2 per cent. In case of unavoidable circumstances in the nature of force majeure, which are beyond the control of the AMCs, the tracking error may exceed 2 per cent, and the same shall be brought to the notice of Trustees with corrective actions taken by the AMC.”

Tracking Difference

According to Parekh, “investors can know the return difference between an ETF and its set Benchmark Index looking at the tracking difference.” In essence, tracking difference is the difference in return of the ETF and its set benchmark.

In its circular, Sebi said that “for Debt ETFs/ Index Funds, the annualised tracking difference averaged over one year period shall not exceed 1.25 per cent.”

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