20 May , 2023 By : Debdeep Gupta
If you don’t make money from your mutual fund scheme, should your fund manager be making any? That’s the idea behind the performance-linked fee, which promises to be a game changer. The challenge will be in its implementation.
The capital markets regulator, the Securities and Exchange Board of India (Sebi), has proposed a drastic overhaul in the way mutual funds (MF) charge their expenses to customers. In a consultation paper issued late in the evening of May 18, it simplified the definition of the total expense ratio (TER), yet made it much tighter by proposing that it include all peripheral expenses that fund houses were allowed to charge over and above the TER.
This confirms an exclusive by Moneycontrol on January 28 that gave a glimpse of Sebi’s plans to cut down expense ratios.
Here are the five big proposals and what they mean for you, the investor.
TER must include brokerage expenses
At present, your equity fund can charge a maximum TER of 2 percent (for the first Rs 250 crore) to investors. Thereafter, the cost comes down to 1.75 percent for the next Rs 1,250 crore, 1.60 percent for Rs 1,500-3,000 crore, and so on. But over and above the TER, your fund can also charge you for other expenses.
At present, fund houses are allowed to charge brokerage and transaction costs of up to 0.12 percent of the trade value. Sebi found that fund houses were charging brokerage amounts that were higher than the amounts charged under TER, and in some cases even double the permissible TER. And investors had been paying that, assuming that they were just paying the TER, which was the only expense they had been told of.
In an internal study that Sebi conducted before it put out its proposals, it observed that fund houses buy brokerage reports, the cost of which they pass on to clients as part of the brokerage cost. This, Sebi says, is wrong, as investors end up paying for research twice; once, by paying management fees to the fund manager, and then again, by paying a higher brokerage.
Dip into the investor education fund; don’t charge the investor
Every year, mutual funds contribute 1 percent of their daily net assets towards an investor education fund. Sebi wants this money to be better utilized. Sebi has proposed that a few key expenses that fund houses used to charge to investors must now be charged to the investor education fund.
Also, it proposed that the B30 commission or commission paid to distributors for soliciting clients from beyond the top 30 towns (called B30 towns in MF industry parlance) should now come out of the investor education fund.
Further, it observed that the investment from B30 towns is usually taken out after a year (B30 commissions are paid only for the first year, after which they revert to normal levels). Unlike market rumors a few months back which suggested that Sebi might scrap B30 incentives altogether, Sebi suggested that the additional commission to distributors can continue beyond the first year for inflows from B30 towns.
Sebi has also proposed that fund houses must incentivize distributors to get more women investors. The commission for this can also come from the investor education fund.
The NFO blow
When a new fund offer (or a newly-launched scheme) collects a handsome figure in its NFO period, you might think that the fund house is popular and investors queued up for it. Not quite.
In an analysis of NFO collections between April 2021 and September 2022, Sebi found that 29 percent of the inflows into NFOs came from existing schemes of the respective fund houses. Curiously, 93 percent of this came from regular plans. Direct plans are meant for those who invest directly with the fund house or through their registered investment advisor. Regular plans are sold by distributors. Moreover, it observed that nearly 72 percent of mutual fund investments were redeemed within two years.
Sebi has now proposed that if distributors switch their money from one scheme to another, he would earn the lower commission of the two schemes.
If you don’t make money from your mutual fund scheme, should your fund manager be making any? That’s a question many investors and market experts have been asking for decades. In its study of mutual fund’s past performance, the Sebi found that just 40 percent of the schemes (regular plans) have outperformed their benchmark indices over the past 10 years. Over the last 5 years, just 27 percent of schemes (regular plans) have outperformed their benchmark indices.
Sebi has set the cat among the pigeons by proposing a performance-linked TER. This proposal is meant to be implemented at an investor level. To put it simply, your fund will charge you management fees (fund manager fees) at the time of redemption. Once you put in your redemption request, your fund house would then quickly calculate whether you’re leaving as a happy customer. In other words, if your money has grown in tandem with or higher than the benchmark index or a hurdle rate (a rate of return the fund house fixes to judge its performance and justify management fees).
If your fund has outperformed, you will receive a slightly lesser amount because the fund house would then deduct its management fee. As of today, fund houses deduct a certain percentage from your corpus throughout your investment tenure regardless of the fund’s performance.
Alternatively, Sebi has suggested that the fund house could charge you a TER (including management fee) through your investment tenure. When you put in a redemption request, the fund house will calculate if it has made more money than its indicated return. If not, it will return the management fee. In this case, you might receive a little more than your corpus at redemption time.
The trouble with the first approach is how would fund houses explain to investors that they deserve a lesser amount than their portfolio value, on account of management fees being suddenly deducted at redemption time. Experts Moneycontrol spoke to said that Sebi would need to move cautiously on this. Sebi has proposed that this can be introduced on an experimental basis, in a sandboxed (test) environment.
Overhaul of TER
Sebi has proposed a complete overhaul of how to fund houses and calculate expenses. At present, every scheme is subjected to a formula — the lower the corpus, the higher the expenses it can charge. As the corpus grows bigger, the expenses go down.
But there were a few problems with this formula. Sebi noted that while fund houses pass on the benefits of economies of scale to debt funds (where mostly large investors invest), retail investors, who mostly invest in equity schemes, don’t get to benefit from lower expense ratios.
Further, at present, individual schemes of the same fund house charge different expense ratios, which allows fund houses to pay different commissions for different schemes. This causes distributors to churn customers from lower commission schemes to higher ones.
Sebi has now proposed category-wise expense ratios. All equity funds will follow a similar expense structure, and all debt schemes will follow a different (albeit lower) TER structure. Hybrid schemes would refer to both these structures; the equity structure would decide how much it can charge for its equity assets, and the debt structure would decide how much it can charge for its debt assets.
The equity and debt assets will be added up, and they will then be assigned an expense ratio based on the slab they fall under. The higher the assets (equity or debt), the lower will be the TER. Once the TER gets decided this way, all equity and debt schemes of the fund house will have to apply that TER.
In other words, a new equity scheme of a fund house will have to charge the same expense ratio as, say, a 20-year-old equity scheme of the same fund house, even though the latter might be 10 times bigger than the new scheme.