The Securities and Exchange Board of India (SEBI), has proposed an overhaul of the existing Expense Ratio structure of mutual funds in a bid to bring transparency in the costs charged to unitholders.

SEBI had introduced the slab-wise Total Expense Ratio (TER) structure for mutual funds, based on the AUM of the schemes, to pass on the benefit of economies of scale achieved by AMCs to investors.

[Read: What Is Expense Ratio in Mutual Funds, And How Is It Calculated?]

Why is SEBI planning to overhaul the existing expense ratio structure for mutual funds?

SEBI noticed that while the TER slabs are presently based on the AUM of the schemes, the AMCs enjoy economies of scale which is linked to their asset class levels (equity, debt, others) and not schemes. Furthermore, the manpower for research and other core activities of AMCs may differ for equity and debt products, but every new scheme does not necessarily attract additional spending towards the core activities of AMCs. Thus, while the size of the asset grows, the cost of investment may not go up in the same proportion and the same results in economies of scale as the AUM grows significantly.

In addition, SEBI observed that AMCs can give higher commissions to distributors for NFOs (new fund launches); this often results in switch transactions from existing large AUM schemes where the average TER a scheme can be charged is less as compared to the NFO scheme where higher TER can be charged. Consequently, AMCs can end up charging higher TER without a substantial increase in AUM or the number of investors.

What changes has SEBI proposed with regard to the expense ratio of mutual funds?

SEBI is of the view that the TER slabs should be at the AMC level and not at the scheme level. In this regard, SEBI has proposed that the AUM of open-ended schemes, wherein slab-based TER is presently applicable, may be bucketed into equity-based AUM (equity & equity-related instruments) and other than equity-based AUM of the AMC (other than equity & equity-related instruments).

Since Overnight Funds of AMCs invest in securities with a maturity of 1 day, which includes overnight repos, TREPS, etc., the AUM of such schemes may not be considered in any of the above-referred buckets for the purpose of calculation of TER. However, the TER rate derived based on all investments other than equity & equity-related product shall be the maximum TER for Overnight funds.

The TER at the AMC level will be inclusive of all costs and expenses, including GST on management fees, brokerage and transaction costs, B-30 incentive etc. The revised TER slabs are proposed to ensure that small AMCs are not at a disadvantage and to encourage competition and a level playing field amongst AMCs of all sizes, which will be in the interest of investors.

In view of the same, SEBI has proposed separate slabs for equity & equity-related instruments and instruments other than equity & equity-related instruments as specified below:

(Source: SEBI Consultation Paper

TER slabs for AUM of other than equity-based AUM (investment in other than equity & equity-related instruments), but excluding the AUM of Overnight schemes, are proposed as under:

(Source: SEBI Consultation Paper

For Hybrid and Solution-oriented schemes, SEBI has proposed that the TER slabs for equity & equity-related instruments be applied for the equity portion of the AUM of schemes, and on the remaining AUM of the scheme, the TER for other than equity & equity-related instruments may be applied. Thus, the TER of Hybrid and Solution-oriented schemes shall be the weighted average of TER of equity & equity-related instruments and TER of other than equity & equity-related instruments. The TER for passive schemes will remain unchanged.

The potential impact of the proposed expense ratio slab on mutual fund investors

SEBI’s impact analysis of the proposed TER slabs has shown that there could be a benefit of reduced expenses for investors of equity, hybrid, and solution-oriented schemes. The analysis further shows that the impact of the revised slabs for debt schemes, even after adding all costs of AMCs towards additional expenses, could be minimal.

Further, with a considerable increase seen in the AUM of the mutual fund industry in the past few years, the proposed new methodology of calculation of TER could bring about transparency and reduction in the cost of investment in mutual funds for investors based on economies of scale. It may also prevent inconsistencies in the charging of expense ratio for different schemes.

This article first appeared on PersonalFN here

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