Before beginning, it is imperative to mention that mutual funds perhaps are the best tool available for Indian Investors.
Rightly so the industry has grown to about INR 40 Trillion and definitely has more legs to grow.
They can auto deduct the money through SIP and thus bring automation and discipline.
They have the best minds studying the ever changing landscape of the markets for you.
They can deliver the much needed inflation beating return consistently.
However even the best have scope for improvement, right?
Well this is what SEBI thinks is the case.
To begin, mutual funds Asset Management Companies (AMC's) operates on a simple premise.
"You win they win
You lose they win"
They shall be taking a small cut known as the Total Expense Ration (TER) irrespective of returns earned by investors. Is it fair, you ask? Read on!
What is Total Expense Ratio (TER)?
TER is a fees charged by the mutual funds to the investors whether or not they deliver on their promises.
This fees basically consists many things like fund manager fees, distributor commission, administrative costs and ofcourse their profits!
Generally these fees for equity funds are in the range of 1-2% approximately depending upon the scheme invested.
Now, this sounds like Mutual Funds entities are bad folks right? Not at all! Look India is a very diverse playing field in terms of investments and Mutual funds have been a catalyst for financialization of savings. However even mutual funds operates for profit and they too have their costs.
Giving a nudge to the retail population is no mean feat. It takes time, effort and cost as well. Therefore SEBI allows mutual funds to charge a cost to the investors.
The present structure of Total Expense Ratios charged by Mutual Funds which is allowed by SEBI is based on the Assets under Management is as follows.
|
Assets
Under Management (AUM) |
Maximum
TER as a percentage of daily net assets |
|
|
TER for
Equity funds |
TER for
Debt funds |
|
|
On the first Rs. 500 crores |
2.25% |
2.00% |
|
On the next Rs. 250 crores |
2.00% |
1.75% |
|
On the next Rs. 1,250 crores |
1.75% |
1.50% |
|
On the next Rs. 3,000 crores |
1.60% |
1.35% |
|
On the next Rs. 5,000 crores |
1.50% |
1.25% |
|
On the next Rs. 40,000 crores |
Total expense ratio
reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets
or part thereof. |
Total expense ratio
reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets
or part thereof. |
|
Above Rs. 50,000 crores |
1.05% |
0.80% |
What is the issue now and is there a need for a change?
Well for starters, SEBI is the apex body who is working for the interest of the investors and also long term improvement of the Mutual Fund industry through policy making.
The sheer concept that fees be charged irrespective of performance can be a real dent on the investor hard earned money.
Further there is no incentive for fund managers who are burning the midnight oil and delivering super returns.
Therefore Both performing and non performing AMC's get similar TER.
Further since there is no extra incentive to deliver outsized returns, therefore fund managers create a replica of index with few modifications and be fine with it. No one complaints for average performance! However People complaints when fund managers take a unconventional bet and markets dont respond to them.
In the last decade, more than 2/3rd Large Cap Mutual Funds are not able to beat the index. Leave aside alpha. Even in such cases, the TER needs to be paid by the investors - this is an real issue.
Anand Barua who is a whole time director of SEBI recently said that a performance linked fee proposal was under consideration in an event organized by the confederation of Indian Industry.
Presently TER is being charged on scheme basis. lower the AUM, higher the fees and vice versa.
Therefore mutual funds can create multiple schemes for different categories, once the scheme reaches a specific threshold to earn higher fees on all schemes.
Further there are also active and passive funds and the fees charged by them can be similar.
What can be the possible options for Performance Linked Incentive for Mutual Funds?
Well the finer details are not out yet and its in proposal stage. There will be an extensive discussion at the regulator level and a consultation paper can be out in the later part of this year.
However to think out loud, there can be two options:
a) Complete performance linked incentives.
Here there are no fixed TER for AMC's.
Performance shall have to be benchmarked. If the performance crosses a certain threshold, they get to earn a % of this extra return.
However if they dont meet the benchmark in a given year (say) they first have to make up till that return. Post that if there is over performance, than they can get an extra cut.
b) Hybrid performance linked incentive.
A fixed TER
and
A smaller Performance incentive (compared to option a) if they cross the benchmark (just as explained above).
What should be the benchmark for Performance Appraisal Incentive?
Sensex has given approximately 12-13% CAGR return since 1990.
Therefore what should be the benchmark rate? FD Rate or NIFTY Return or something else?
It needs to be carefully thought about. Since if the target return is too low like FD, than the performance shall be regularly met and investors will lose due to extra performance incentives.
However if target return is too lofty say 20% p.a. than either the fund manager might take inordinate amount of risks therefore putting the capital at significant risks or might not remain interested at all to deliver high returns.
However benchmarking to respective Index return can be a good way to start though!
Eg. For small cap fund - S&P BSE Small Cap Index
For Large cap Fund - Nifty
Ok - Are there any other changes in TER?
You see, there is definetely a strong push by SEBI to cut down on TER for benefit of the investors since the industry has been maturing enough now. So proposals are in those lines.
The following might be the possible changes in the Total Expense Ratio in the coming future.
AMC are currently allowed to pay slightly higher distributor commission to investors who come from B30 (Beyond Top 30 Cities) to bring financial awareness to smaller towns and cities if few criteria are satisfied. This extra distributor commission for B30 Cities may be disallowed.
Further the TER can be charged based on the complete Asset Class held by the AMC and not on a scheme level. Asset classes may be classified as equity and debt. However SEBI may make room for active and passive bifurcation as well.
Eg. SBI MF launching a new scheme today is allowed to charge TER upto 2.25% upto an AUM of Rs. 500 Crore, however if the TER is based on Asset Class, than since SBI MF already has AUM of more than 50,000 Cr therefore the TER charged can be maximum limited to 1.05% based on current rates.
Is Performance Linked Incentive a sureshot for success?
In Mahendra Singh Dhoni's style, the answer is "DEFINETELY NOT"
Well performance linked fees are not a new kid on the block. They are already there for Portfolio Management Services in India. However most Portfolio Management Services fail to beat Mutual Funds.
So there is no surety for success. However there can be a window for improvement as the interests of the AMC's and investors are aligned.
This has been tried in international markets as well, however this has not been a direct parameter to higher returns.
However SEBI shall take all this into consideration .Till then, We shall wait to see how things pan out.
Despite all things said and done, if there is one industry who is most compatible to changes - it is definetely the mutual fund industry. You just cannot bet against them. So they will be ready whatever be the outcome.
What is your take on the matter? Do let me know your feedback.
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The writer is a passionate student of finance and markets.
CA Parth Shah
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