MARKET INDEX PROVIDERS

28th March, 2023 Economy

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Context

The government has put the onus of regulating the practices of Market Index Providers on the Securities Exchange Board of India (SEBI).

What is Market Index?

A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market.
The calculation of the index value comes from the prices of the underlying holdings.

Market Index Providers

An index provider is a specialized firm that is dedicated to creating and calculating market indices and licensing its intellectual capital as the basis of passive products.
One of the important roles of the index provider is to classify and define markets, as their indices represent a market, or a proportion of a market, and provide a benchmarkof performance for that market or sector.
Thus, Index providers are those institutions that formulate and manage indices.

Examples

Some of the important indices in India are: Benchmark indices – BSE Sensex and NSE Nifty.
Sectoral indices like BSE Bankex and CNX IT. Market capitalization-based indices like the BSE Smallcap and BSE Midcap.
S. examples include the Dow Jones Industrial Average, Bloomberg, the Standard and Poor's 500 Index, and the Wilshire 5000 Index.

Utility

A market index follows a certain market and gives investors a single number to summarize its ups and downs.
It enables the world's institutional (and retail) investors to track a market or market sector without having to aggregate the underlying components.
Index is the most essential element in stock market trading, as it helps investors gauge the overall market sentiment.
Moreover, several indices are linked to financial products, such as exchange-traded derivatives, index funds, exchange-traded funds (ETFs), and market-linked debentures. Indices are also used as a benchmark for actively managed mutual funds.

An index allows investors and other stakeholders to get a snapshot of the market.

Need for regulation

Since the services of these index providers determine the level of investment in the market through passive mutual fund schemes, it is necessary to regulate these institutions to safeguard investor interests.

Current status of Regulation

Currently, index providers are outside the purview of SEBI. However, SEBI had issued a code of conduct for them in 2017.
Currently, exchange platforms and rating agencies offer index services which are widely used by mutual funds and insurance companies to track performance and offer ETFs and index funds.

Concern

A conflict of interest could arise in the governance and administration of indices and benchmarks because of the discretion in the management of indices by Index Providers. For instance, the rebalancing of the constituents of an index happens at the discretion of the index provider.
The role of stock selection performed by the fund managers of index funds has been delegated to the Index Providers to a certain degree. The inclusion or exclusion of stock in the index may also have an impact on the volume, liquidity, and price of the stock.
In a nutshell, decisions made by index companies had a significant impact on the return of the index funds.
After all, the benchmarks were supposed to merely reflect the market. But today they constitute a recommendation of what securities to buy, and were offered to a broad audience rather than directly to a client.

New Regulatory Framework [Protocol]

All Index Providers (IP) offering services to Indians will have to get themselves registered with SEBI. However, administrators providing benchmarks notified by the Reserve Bank of India will be excluded from this mandatory requirement.
The index provider should be a legal entity incorporated under the Companies Act in the country of origin, and independent professionals -- individual or group of persons -- providing index/benchmark services should be considered ineligible.
IPs must have net worth of at least Rs.25 crore.
IPs must have at least a 5-year track record in index administration. Alternatively, IPs should have at least two employees, each having minimum 5 years of relevant experience.
IPs will have to constitute an oversight committee for reviewing existing index design and proposed changes to benchmark methodology. The committee will also oversee audit results and the implementation of audit observations.
IPs will have to follow policies/procedures to manage conflicts of interest.
IPs will have to prevent sharing and leakage of any sensitive information.
IPs will have to document their methodology for index calculation publicly.
IPs will have to offer a grievance redressal mechanism including an online facility for arbitration between the index provider and customer/client.
Index providers will also “be assessed by independent external auditors to evaluate adherence to [International Organization of Securities Commissions] principles once in two years.
The proposed regulations require maintaining all audit records and making them available for SEBI when asked for. This ensures a high degree of governance and accountability from the index providers.
SEBI proposes that the index providers need to consider all relevant data for creating an index. It also needs to exercise enough care and caution to ensure that there is no distortion of the data. It needs to exercise due diligence in the onboarding of data submitters. And, importantly, the index provider has to ensure that the data submitters source data from only regulated entities and no other sources. It ensures the quality and reliability of input materials used in constructing the index.

If SEBI determines any adverse findings about the administration of such indices and/or non-adherence to any of the stated principles, SEBI at its sole discretion will have the right to take appropriate action.

Applicability

The proposed regulation shall be applicable to index providers (both domestic and foreign) if the users of the index/products based on the index are located in India

Significance

Today, there are more than 200 passive products, including Exchange Traded Funds or index funds in the Indian capital markets, compared to just 8 products in 2008.
With the exponential increase in the number of passive funds and the asset under management of these funds, the governance of the indices assumes greater significance.
The move will further transparency and accountability in financial benchmarks/indices in the Indian securities market.

Read about SEBI in detail: https://www.iasgyan.in/daily-current-affairs/securities-and-exchange-board-of-india-seb

EXCHANGE-TRADED FUNDS

Exchange Traded Funds or ETFs are a basket of stocks that mirrors a benchmark Index. So, if one wishes to invest in the 50 stocks of Nifty, then she could simply buy an ETF, and the returns generated by ETF and Nifty 50 would be the same. Moreover, ETFs are tradeable; hence, she can buy them anytime during market hours, and they will be allotted to her at the current price. All ETFs are passively managed. So, the aim of ETFs is not to beat the benchmark index but to replicate their performance.

Types of ETFs

There are various ETFs such as Gold, Currency, Index, Bank, Liquid, and international.

Index ETFs: This is the most commonly known type of ETF. Investment in Index ETFs should generate the exact returns of the benchmark index like Nifty50 and Sensex, nothing more or less than the benchmark.

Gold ETFs: Instead of buying digital gold, she can opt for Gold ETFs. It tracks the price of 24-carat pure physical domestic gold and replicates it. It is beneficial as it is tradeable, and she can invest a small amount.

Bank ETFs: These track a bucket of banking stocks listed in the stock market. It may have Bank Nifty as its benchmark and offer returns according to the performance of Bank Nifty.

Liquid ETFs: It invests in a basket of government securities or money market instruments for the short term. The prices are not very volatile, but it offers stable returns.

International ETFs: These track global market indices like Nasdaq, Hang Seng, Nikkei, etc. These ETFs are excellent investment options for someone looking to diversify their investment portfolio into foreign markets.

Advantages

Tradable: The most significant advantage of ETFs is that they are tradable.

Cost efficient: ETFs and mutual funds belong to almost the same family regarding taxes. Both investment options are subject to capital gain tax. But, the expense ratio of ETFs can be as low as 0.25%, compared to mutual funds, which are usually 1.5% - 2.25%.

Zero exit load: No matter when one sells an ETF, there is no exit load like mutual funds.

Taxation

ETFs are taxed in two ways - equity-oriented and non-equity-oriented ETFs.

Equity-oriented ETF: If one invests in an index ETF or equity ETF and hold it for less than a year, then short-term capital gain tax will be levied at 15% + 4% cess. If she holds it for more than a year, then long-term capital gain tax will be levied at 10% without indexation above Rs 1 lakh.

Non-equity-oriented ETF: If one invests in gold ETF, liquid ETF or international ETF, then it is treated as a non-equity ETF.

If she holds the investment for less than 36 months, the tax will be levied as per her tax slab. If she hold for more than 36 months, then a tax of 20% after the indexation benefit will be levied.

Important Link: https://www.iasgyan.in/daily-current-affairs/gold-exchange-traded-funds-etfs

PRELIMS PRACTICE QUESTION

Q. According to the new regulations notified by SEBI with respect to Market Index providers in India, which of the following statements are correct?

a) Index Providers (IPs) must have a net worth of at least Rs.50 crore.

b) IPs must have at least a 5-year track record in index administration.

c) Index providers will be assessed by independent external auditors to evaluate adherence to International Organization of Securities Commissions principles once in two years.

d) SEBI regulation shall be applicable to index providers (both domestic and foreign) if the users of the index/products based on the index are located in India.

1) a and c

2) c and d

3) b, c and d

4) a, b and c

Answer: 3