SEBI eases the sponsor group-company exposure cap for passive schemes: what index-fund and ETF investors should understand

On 8 July 2024, SEBI issued circular SEBI/HO/IMD/IMD-PoD-2/P/CIR/2024/098, quietly rewriting one of the most consequential rules for anyone who owns a passively managed fund in India. The change follows the amendment to the SEBI (Mutual Funds) Regulations, 1996 notified on 2 July 2024 (notification SEBI/LAD-NRO/GN/2024/188), and it affects every equity-oriented index fund and exchange-traded fund that tracks a large, mainstream benchmark. For investors deciding between the two main passive formats — a conventional index fund versus an ETF — the rule removes a hidden source of underperformance that had nothing to do with the fund manager's skill.

The background is a prudential limit found in clause 9 of the Seventh Schedule to the MF Regulations. It bars any mutual fund scheme from holding listed securities of the sponsor's group companies in excess of 25 per cent of the scheme's net assets. That ceiling makes sense for an actively managed fund, where the manager chooses the holdings. But for a passive scheme, the holdings are dictated by the index, not the manager — so when a sponsor-group stock carried an index weight above 25 per cent, the fund was forced to underweight it, producing structural tracking error that penalised investors through no fault of the index.

The 8 July 2024 circular carved out a tightly defined exception. Equity-oriented ETFs and index funds based on "widely tracked and non-bespoke" indices may now invest in line with the weightage of each constituent in the underlying index, subject to a revised overall cap of 35 per cent of the scheme's net asset value in the sponsor's group companies. The table below sets out the before-and-after position.

SEBI defined the qualifying universe precisely to prevent gaming. Under paragraph 3.2 of the circular, "widely tracked and non-bespoke indices" are those tracked by passive funds, or which act as the primary benchmark for actively managed funds, with collective assets under management of Rs 20,000 crore and above. The qualifying list is determined half-yearly as on 31 March and 30 September, and AMFI publishes the updated list on its website by 15 April and 15 October each year (paragraph 3.3). The first list, as on 30 June 2024, was annexed to the circular itself.

Side-by-Side Comparison

Index funds and ETFs are the two vehicles through which Indian retail investors take passive exposure, and the 8 July 2024 rule benefits both equally where they track a qualifying index. The practical differences lie in how you buy, price and hold them. The table below compares the two formats across the dimensions that matter for a buy-and-hold investor in 2026.

The sponsor-group rule is identical for both formats because the 35 per cent cap attaches to the scheme, not to its wrapper. What differs is execution. An index fund removes the friction of a demat account and supports a rupee-cost-averaging SIP, which is why it suits an investor automating a monthly contribution. An ETF settles on the exchange at a live price and can occasionally trade away from its NAV; the bid-ask spread and any premium or discount are an additional, less visible cost on top of the published expense ratio. For a widely tracked large-cap index with deep liquidity, that gap is usually small, but it is not zero, and it recurs on every transaction.

There is a second, subtler point the circular surfaces. Before 8 July 2024, two funds tracking the same index could deliver different returns purely because one was run by a sponsor whose group company sat heavily in that index. The sponsor-affiliated fund was forced to cap the stock at 25 per cent while a non-affiliated competitor could hold the full index weight, so the affiliated fund lagged on structural grounds. The revised 35 per cent cap narrows that distortion for qualifying indices, so the choice between a sponsor-linked and an independent AMC now turns on cost and tracking record rather than on an artificial regulatory handicap.

Funds that do not qualify — those tracking bespoke or thinly followed indices below the Rs 20,000 crore threshold — remain bound by the 25 per cent limit and had to rebalance their portfolios within 30 business days of the circular's issuance under paragraph 3.5. Where a scheme could not rebalance in time, paragraph 3.6 required a written justification before the AMC's Investment Committee, which could extend the timeline by up to 60 business days. Paragraph 3.7 adds teeth: an AMC that still fails to rebalance may not launch any new scheme until it does, and may not levy an exit load on investors leaving the non-compliant scheme.

Tax Treatment

Because both an index fund and an ETF tracking an equity index are equity-oriented schemes, their taxation is identical and flows from the Budget 2024 changes effective 23 July 2024. Gains are classified by holding period, and the rates below apply regardless of which format you held. The figures come from the capital-gains provisions of the Income-tax Act as administered through incometax.gov.in.

The LTCG exemption of Rs 1,25,000 is an annual, per-investor threshold that applies across all your equity-oriented funds and listed shares combined, not per scheme. A health and education cess of 4 per cent is added on top of the tax in both cases. To see the arithmetic concretely, take an illustrative LTCG of Rs 2,00,000 realised after holding units for more than 12 months: the first Rs 1,25,000 is exempt under Section 112A, leaving Rs 75,000 taxable at 12.5 per cent, which is Rs 9,375, plus 4 per cent cess of Rs 375, for a total of Rs 9,750.

By contrast, if the same Rs 2,00,000 gain were short-term — booked within 12 months — Section 111A would apply a flat 20 per cent with no exemption, giving Rs 40,000 of tax plus Rs 1,600 cess, a total of Rs 41,600. The gap of Rs 31,850 between the two outcomes on an identical Rs 2,00,000 gain is the single strongest argument for holding a passive equity fund beyond the 12-month line before redeeming. You can model your own holding-period and gain scenarios with the lumpsum calculator or, for a staggered entry, the SIP calculator.

One structural tax note separates the two formats in practice. An ETF investor who wants to switch benchmarks must sell units on the exchange, triggering a capital-gains event; an index-fund investor using a switch within the same fund house faces the same treatment, because a switch is a redemption plus a fresh purchase for tax purposes. Neither format offers an indexation benefit on equity gains, which was never available under Section 112A for listed equity, so the 12.5 per cent LTCG rate is applied to the full nominal gain above Rs 1,25,000.

Who Should Pick Which

The 8 July 2024 rule equalises the index-tracking fidelity of qualifying funds, so the decision between an index fund and an ETF should rest on your account setup, contribution pattern and sensitivity to execution cost. Below are the investor profiles that map cleanly to each format.

Choose an index fund if you invest through monthly SIPs. The format supports automated instalments from as little as Rs 100-500, needs no demat account, and transacts at a single daily NAV, which removes the timing and spread decisions an ETF demands on every purchase. For a disciplined investor adding to a Nifty or Sensex tracker every month, the index fund is almost always the lower-friction route, and the 35 per cent group-company cap under the 2024 circular ensures the fund hugs the index rather than carrying a built-in handicap.

Choose an ETF if you already hold a demat account and value intraday pricing. An investor deploying a large lumpsum in one transaction can often secure a marginally lower expense ratio through an ETF, and the live exchange price lets you act on an intraday level rather than accepting an unknown closing NAV. The trade-off is brokerage, securities transaction tax and the bid-ask spread on each trade, plus the risk of buying at a premium to NAV in a thinly traded ETF — so this route rewards investors who transact infrequently and in size. Use the lumpsum calculator to weigh a one-shot ETF purchase against a phased SIP.

For either format, favour funds tracking a qualifying index. Because the 35 per cent cap and faithful index-weighting apply only to widely tracked, non-bespoke indices above the Rs 20,000 crore AUM threshold, a fund built on a niche or custom index still operates under the old 25 per cent restriction and may deviate from its stated benchmark. Confirm that your chosen fund's underlying index appears on the half-yearly list AMFI publishes by 15 April and 15 October before assuming the sponsor-group relaxation applies to it.

Investors seeking a tax-linked equity route alongside a plain index tracker should note that an ELSS fund remains the only equity category offering a Section 80C deduction, though with a three-year lock-in and active management rather than passive index replication. For readers building the passive core of a long-horizon portfolio, pairing a low-cost index tracker with periodic SIP top-ups generally captures the market return at minimal cost once the sponsor-group distortion is removed.

FAQ

What exactly did SEBI change on 8 July 2024 for passive funds?

SEBI streamlined the prudential norm in clause 9 of the Seventh Schedule to the MF Regulations. Equity-oriented ETFs and index funds tracking widely tracked, non-bespoke indices may now hold sponsor group-company securities in line with the index weight, subject to an overall cap of 35 per cent of NAV, up from the earlier flat 25 per cent ceiling (circular SEBI/HO/IMD/IMD-PoD-2/P/CIR/2024/098).

Does the 35 per cent cap apply to every index fund and ETF?

No. Under paragraph 3.2 of the circular, the relaxation is limited to indices tracked by passive funds or used as the primary benchmark for active funds with collective AUM of Rs 20,000 crore and above. Funds tracking bespoke or smaller indices remain subject to the 25 per cent limit, and had to rebalance within 30 business days of 8 July 2024 under paragraph 3.5.

How is the list of qualifying indices maintained?

The qualifying list is determined half-yearly, as on 31 March and 30 September, against the Rs 20,000 crore AUM threshold. AMFI updates and publishes the list on its website by 15 April and 15 October each year (paragraph 3.3). The inaugural list, as on 30 June 2024, was annexed to the circular.

Are index funds and ETFs taxed differently?

No. Both are equity-oriented schemes, so gains held for more than 12 months are long-term and taxed at 12.5 per cent under Section 112A above the annual Rs 1,25,000 exemption, while gains held for 12 months or less are short-term and taxed at 20 per cent under Section 111A. A 4 per cent cess applies in both cases, with rates effective from 23 July 2024.

Does an ETF's market price always equal its NAV?

Not necessarily. An ETF trades on the exchange at a live market price that can sit at a premium or discount to its NAV, especially in thinly traded funds. An index fund, by contrast, transacts strictly at the day's closing NAV, so there is no premium-or-discount risk, though you cannot act on an intraday price.

Why did a sponsor-affiliated fund previously lag an independent one on the same index?

Before 8 July 2024, the flat 25 per cent cap forced a fund to underweight a sponsor group-company stock whenever its index weight exceeded 25 per cent, creating tracking error that an independent AMC's fund on the same index did not suffer. The revised 35 per cent cap narrows this structural distortion for qualifying indices.

What happens if a passive fund fails to rebalance in time?

Under paragraphs 3.6 and 3.7, a fund that cannot rebalance within 30 business days must place a written justification before the AMC's Investment Committee, which may extend the timeline by up to 60 business days. If it still fails, the AMC cannot launch any new scheme until compliance is restored and cannot levy an exit load on investors exiting the non-compliant scheme.