ETF Choices To Shrink? SEBI May Cut Lookalike Passive Funds But MF Industry Not Enthused

India's mutual fund industry is pushing back against a proposal by the Securities and Exchange Board of India (SEBI) to extend its 50% portfolio overlap rule to sectoral and thematic passive funds, a move that could slow new scheme launches in one of the fastest growing segments of the market, sources within the industry tell NDTV Profit. 

The rule, introduced in February for active sectoral and thematic schemes, bars fund houses from offering two schemes with more than 50% overlap in portfolios. SEBI is now considering applying the same principle to passive products such as index funds and exchange traded funds, especially in sectoral and thematic categories, sources say. 

The proposal targets a sharp rise in passive fund launches. Assets in passive funds have expanded rapidly and the number of schemes has surged in recent years, with many tracking similar themes and holding overlapping stocks.

SEBI is also weighing limits on smart beta funds, with plans to cap how many factor-based products each AMC can launch to curb a surge in similar offerings.

Asset managers have leaned on low-cost, scalable passive launches to drive fee income, using multiple thematic variants to gather assets, and SEBI's overlap cap threatens to curb that model by limiting new scheme launches.

“Fifty percent is very aggressive,” said a senior AMC executive. “It will eliminate benchmark-plus products, which are a big source of revenue for ETF players.”

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SEBI trying to reduce duplication

If a fund house already has a passive scheme tracking one index, it may be barred from launching another scheme tracking a very similar index with more than 50% overlap.

For example, an Asset Management Company might launch a Digital India Index Fund and a Technology Leaders Index Fund. Because India's tech sector is concentrated, both indices might hold the exact same top 5 tech companies making up 70% of the index weight. If such a rule comes into existence, it would prevent a single fund house from launching multiple such lookalike products.

This is especially visible in sectoral and thematic passive funds. Because these funds track narrow indices, different schemes often end up holding the same set of large companies.

“The idea of an overlap cap is not to prevent overlap in the portfolio, because passive funds must follow their indices. It is to limit the number of very similar passive schemes that an AMC can launch and avoid unnecessary product clutter for investors,” explains Nishant Prasad, a partner at Finsec Law Advisors.

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Industry opposition

“That is the big cash cow for ETF providers. They will fight back hard,” one industry executive said on condition of anonymity.
Mutual funds earn revenue through expense ratios, which are charged as a percentage of assets under management. More schemes and more assets translate into higher fee income.

Passive funds have become a key growth driver in this model. They are cheaper to run than active funds and easier to scale. Launching a new index fund typically requires tracking an existing or newly created benchmark, without the cost of active stock selection.

This has led to a proliferation of schemes, particularly in thematic categories where fund houses can create multiple variants around similar ideas.

Industry executives say the overlap rule could directly hit this strategy by limiting how many such products can be launched.

Fund managers and product teams are also incentivised to launch new schemes. New fund offers attract flows, generate visibility and provide fresh inventory for distributors to sell. Restricting launches could therefore affect asset growth and distribution momentum.

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