The 2022 SEBI circular that built the rulebook for India's index fund and ETF boom

On 23 May 2022, the Securities and Exchange Board of India issued Circular SEBI/HO/IMD/DOF2/P/CIR/2022/69, titled "Circular on Development of Passive Funds", through its Investment Management Department. It was the first time Indian passive schemes - index funds and exchange-traded funds (ETFs) - were given a dedicated regulatory track rather than being governed by rules written for actively managed funds. For the ordinary investor deciding between an index fund and an ETF that both track, say, the Nifty 50, this 2022 circular is the quiet reason the choice is now far more transparent than it was before.

This Midday Investment Pulse breaks down what that circular actually changed, how an index fund differs from an ETF after those changes, and - using only the capital-gains constants published in our rate configuration and the disclosure norms laid down by the regulator - which structure suits which kind of investor in the financial year 2025-26.

The headline number from the circular matters most: an index fund should endeavour to keep its tracking error within 2% per annum under normal circumstances. That single threshold, published in May 2022, is the benchmark against which every index fund investor can now hold a fund accountable.

What the 2022 circular actually changed

Before 23 May 2022, passive schemes borrowed their disclosure and launch rules from the active-fund rulebook, even though a fund that merely copies the Nifty 50 does almost nothing an active fund manager does. The SEBI 2022 circular corrected three specific gaps.

First, it set a quantitative ceiling on deviation. Under the circular, an index fund must endeavour to keep its tracking error - the annualised standard deviation of the difference between the fund's daily returns and its benchmark's daily returns - within 2% per annum under normal circumstances. A fund that drifts persistently beyond that 2% band is, by the regulator's own 2022 yardstick, not doing its one job.

Second, it mandated disclosure of both tracking error and tracking difference. Tracking difference is the simpler, blunter figure: the plain gap between the fund's return and the index's return over a period, which captures the drag from the expense ratio and cash holdings. By requiring asset management companies to publish both figures from 2022 onward, the circular let an investor comparing two Nifty 50 funds see, in one glance, which one actually delivers returns closer to the index.

Third, the circular gave passive schemes faster launch timelines and separate, slimmed-down disclosure formats distinct from active-scheme norms. Because an index fund's holdings are dictated mechanically by the index it follows, SEBI accepted in 2022 that it need not carry the same forward-looking risk narrative an active fund must. This lowered the cost of bringing new passive products to market, and the passive category has expanded sharply in the years since the circular took effect.

The practical upshot of these 2022 measures is that the index-fund-versus-ETF decision is no longer a leap of faith. Both structures now disclose tracking error against the same 2% reference, so the comparison below rests on verifiable, regulator-mandated data rather than marketing.

Side-by-Side Comparison

An index fund and an ETF can track the identical index - the Nifty 50, say - and yet behave very differently in your hands. The index fund is a conventional mutual fund scheme you buy and sell at the day's net asset value; the ETF is a unit that trades on the exchange through a demat account at a live market price. The 2022 circular applies its tracking-error and disclosure norms to both, which is what makes a like-for-like comparison fair.

The decisive difference the 2022 circular highlights is how deviation shows up. For an index fund, you always transact at NAV, so the only slippage you suffer is the published tracking error and tracking difference. For an ETF, you face a second, separate risk: the market price at which you trade can drift from the fund's underlying indicative NAV (iNAV) when on-exchange liquidity is thin, a gap the SEBI 2022 market-making provisions were designed to narrow but cannot eliminate.

The cost comparison usually favours the ETF on paper. ETFs typically carry the lowest expense ratios in the passive category, which, over a 20-year horizon, compounds into a visible difference - you can model this using our lumpsum calculator or a disciplined SIP plan. But the ETF's exchange-traded nature adds brokerage and securities transaction tax (STT) on every buy and sell, and if you trade at a price worse than iNAV, that invisible cost can quietly erase the expense-ratio saving.

Tax Treatment

Here the two structures are treated identically, provided the scheme is equity-oriented - which Nifty 50 and Sensex index funds and ETFs are. Taxation follows the Budget 2024 regime that took effect on 23 July 2024, and the figures below come straight from our rate configuration, not from estimates.

For an equity-oriented index fund or ETF held for 12 months or less, short-term capital gains are taxed at a flat 20% under Section 111A of the Income-tax Act, 1961. For units held longer than 12 months, long-term capital gains are taxed at 12.5% under Section 112A, with the first Rs 1,25,000 of such gains in a financial year exempt. These rates apply equally whether you hold the index fund or the ETF, so tax is not a tie-breaker between the two structures.

One tax nuance does separate them in practice. Because you transact an index fund at NAV without a broker, you control exactly when you redeem and can harvest the Rs 1,25,000 annual LTCG exemption cleanly each year after 23 July 2024. With an ETF, you can do the same, but only by placing exchange orders that may execute at a price away from iNAV, which slightly muddies the arithmetic of a precise tax-harvesting plan. Investors modelling the after-tax outcome of a long equity hold can sense-check the gross figure with our SIP calculator before applying the 12.5% LTCG rate.

Note that debt ETFs and international ETFs are taxed differently from equity schemes; the equity rates above apply only to domestic equity-oriented passive funds. Always confirm the scheme's equity orientation in its scheme information document before assuming the 12.5% long-term rate from 23 July 2024 applies.

Who Should Pick Which

The 2022 circular made both structures transparent, but it did not make them interchangeable. The right choice turns on how you invest, not on which product is theoretically cheaper.

Choose the index fund if you invest through monthly SIPs and value automation. Because the SEBI 2022 framework lets you transact at NAV with no demat account, an index fund supports a native, set-and-forget SIP that debits your bank account on a fixed date, with no brokerage on each instalment. For an investor building a 15-to-20-year equity corpus through disciplined monthly contributions - the use case our SIP calculator is built around - the index fund's slightly higher expense ratio is a small price for zero execution friction and no price-iNAV slippage.

Choose the ETF if you already hold a demat account, deploy lumpsum amounts, and are comfortable placing exchange orders near iNAV. The ETF's rock-bottom expense ratio rewards the investor who buys in larger, less frequent tranches, where brokerage and STT on each trade are spread thin. An investor deploying a one-time windfall and planning to hold for more than 12 months to qualify for the 12.5% LTCG rate can reasonably favour the ETF, and should model the deployment using our lumpsum calculator.

For either choice, the single most important selection criterion the 2022 circular hands you is tracking error. When two funds track the same index, pick the one with the lower tracking error and lower tracking difference - both now mandatorily disclosed since 23 May 2022. A fund persistently drifting toward the 2% ceiling is giving you index-minus returns, whichever wrapper it comes in.

FAQ

What is the 2% tracking-error limit in the SEBI 2022 circular?

Under SEBI Circular SEBI/HO/IMD/DOF2/P/CIR/2022/69 dated 23 May 2022, an index fund should endeavour to keep its tracking error - the annualised standard deviation of the daily return difference between the fund and its benchmark - within 2% per annum under normal circumstances. It is a reference ceiling, and well-run funds usually run far below it; a fund hugging 2% is poorly replicating its index.

Is an index fund or an ETF cheaper?

ETFs typically carry the lowest expense ratios in the passive category, so on paper the ETF is cheaper. But an ETF adds brokerage and securities transaction tax on every exchange trade, plus the risk of trading at a price away from its iNAV when liquidity is thin. For a small monthly SIP, an index fund's all-in cost is often lower in practice despite the higher headline expense ratio.

Are index funds and ETFs taxed differently?

No, not when both are equity-oriented. Following Budget 2024, effective 23 July 2024, both attract 20% short-term capital gains under Section 111A if held 12 months or less, and 12.5% long-term capital gains under Section 112A above a Rs 1,25,000 annual exemption if held longer. The wrapper does not change the equity tax treatment.

Do I need a demat account to buy an index fund?

No. An index fund is a conventional mutual fund scheme bought at NAV directly from the asset management company, so no demat account is required. An ETF, by contrast, trades on the exchange and does require a demat and broking account, a distinction the SEBI 2022 framework preserves.

What is tracking difference, and how is it different from tracking error?

Tracking difference is the plain gap between a fund's return and its benchmark's return over a period, capturing the drag from the expense ratio and cash holdings. Tracking error measures the volatility of that gap as an annualised standard deviation. The 2022 circular made asset management companies disclose both, so you can judge a passive fund on consistency as well as average shortfall.

Did the 2022 circular make it easier to launch passive funds?

Yes. The circular gave passive schemes faster launch timelines and separate, slimmed-down disclosure formats distinct from active-fund norms, recognising that an index fund's portfolio is dictated mechanically by its index. Lower launch friction since 23 May 2022 is one reason the number of index funds and ETFs available to Indian investors has grown so quickly.

Where can I verify the SEBI 2022 circular myself?

The full text is published on the regulator's website at sebi.gov.in under Legal - Circulars for May 2022. For benchmark index data and industry-level passive-fund figures, the Association of Mutual Funds in India publishes monthly data at amfiindia.com. Always cross-check a specific fund's tracking error in its latest factsheet before investing.