SEBI is revisiting Total Expense Ratio (TER) rules for mutual funds, which account for various costs including management fees, marketing costs, administrative expenses, etc. The current model allows mutual funds to charge investors based on the type of scheme and Assets Under Management (AUM). In 2012 and 2018, four extra charges were added to the allowable costs, including brokerage & transaction costs, inflows from B-30 cities, exit load provisions, and goods and services tax.
SEBI now proposes a uniform TER at the Asset Management Company (AMC) level instead of the scheme level, which could lower costs for investors. It's suggested that all costs, including brokerage and transactions, be included in TER for increased transparency and accountability.
Brokerage and Transaction Costs
SEBI observed that AMCs have executed trades with brokers at high costs compared to top brokers and availed research services from them, and is of the view that in such circumstances, investors end up paying twice for research, once as investment management fee, and again as brokerage. In simple language, SEBI is saying that some funds are outsourcing their core function and are making the investors pay for it. In this regard, it has been proposed to include the cost of brokerage and transactions within TER, which would, among other things, increase transparency and create accountability. This becomes an issuewhere investments are made in under-researched small cap companies for instance, where the economies of scale of a broker researching for thousands of clients may reduce costs.
B – 30 Cities
SEBI's study revealed discrepancies in additional charges related to inflows from B-30 cities. SEBI now proposes that only actual costs towards distribution commission be charged and payments be restricted to new investors at the industry level, up to a certain limit.
AUM-Level TER
In one of the most important proposals, SEBI has proposed to shift the TER from being calculated on the scheme level to the AMC level. This may be one of the first global regulatory actions of it's kind. As a result of the current structure, the AMCs have the benefit of their entire asset class, and the expenses towards core activities of the AMC do not increase significantly upon setting up a new scheme. Further, the present mechanism allows an AMC to charge a higher TER in a new fund offering with a smaller AUM compared to existing, larger schemes with larger AUM, resulting in higher TER being charged without a substantial or corresponding increase in AUM or investors. Consequently, mutual funds have the incentive of launching new schemes with low AUM and high TER, which leads to distributors churning their investment portfolio or mis-sell products for higher commissions. To prevent this, SEBI has proposed that a distributor will only be entitled to the lower commission offered out of the two schemes in a switch transaction. Further, observing that costs may differ on account of equity & related products, and other products, the Regulator has proposed to make the TER slabs applicable at the AMC level instead of the scheme level, and has proposed to specify higher TER limits in order to cover all costs and expenses, including GST, etc. While this is a good move, any impact on specific schemes should be observed and course correction done by providing exemptions over a period of time.
Performance-based TER
Presently, management fees and expenses are charged on a daily basis, irrespective of the performance of the scheme. Relying on data pertaining to the last 10 years, SEBI has, among other things, observed that more than 22% of the regular plans have underperformed by more than 1.25%. While certain unpredictable or unavoidable factors can lead to not meeting the benchmark, significant underperformance of the fund is obviously not in its unitholders' interests. Moreover, AMCs exceeding their benchmarks may be incentivized by allowing them to charge a fee based on their performance. Thus, the Regulator has suggested enabling performance linked TER, in terms of which the AMC can charge higher management fees and has proposed two approaches for the same. Broadly, the first approach involves charging the investor at a higher management rate at the time of redemption, and the second approach involves charging the higher fee at the time of subscription, but returnable in case the benchmarks are not crossed.
Given the novelty of the concept of a performance based TER, SEBI has proposed to test the model under the regulatory sandbox first, so it might be some time before this proposal is rolled out. This is great in theory, but nearly impossible to implement because of the simple problem that returns are a combination of luck and skill. It is nearly impossible to break up the two over any short to medium period of time. Introduce the variable of daily charges which are deducted and the investor who enjoys the performance (filtered for luck after say 3 or 5 years) would unlikely be the same investor who pays for the extra performance. A lot more thought needs to be put in before a system which rewards performance in a mutual fund matches performance with payback, specially when investors are moving in and out daily. Besides, even on a longer time scale, some funds will get rewarded on the infinite monkey hypothesis. The hypothesis is that if you train an infinite number of monkeys to type randomly, one of them will eventually come out with Hamlet. But don't count on the same monkey to type Macbeth next.
Conclusion
While the Regulator appears to be right track, it must balance the objective of passing on the benefits of economies of scale to the investors with leaving enough room to ensure growth of the mutual fund industry. The previous adverse impact has been forgotten in light of the huge increase in the assets of the entire industry. One hopes, that gets repeated making it a win-all for all.
[Note: This article originally appeared on Economic Times, and can be accessed here.]
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