Market regulator SEBI recently released a consultation paper to review the total expense ratio (TER) of mutual funds. It has proposed a host of changes to improve transparency in the total expenses charged to investors, pass on the benefit of economies of scale to investors, remove dual charges (if any), and address the issue of churning of investors’ portfolio, among others.
Based on various observations, SEBI has proposed multiple reforms for expense ratio as under:
Observation 1: SEBI has observed that spending of some schemes towards brokerage and transaction cost is more than even the maximum TER limits prescribed. This has resulted in investors paying more than double the permissible TER limits prescribed for the scheme towards expenses.
Proposal: SEBI has proposed bringing brokerage and transaction expenses within TER limits, and the transaction-wise limits prescribed for additional expenses towards brokerage may not be applicable. This is expected to bring transparency in the costs charged to the unitholders and greater accountability in respect of brokerage costs. SEBI has also proposed to allow AMCs to obtain limited-purpose membership with stock exchanges for executing trades for their mutual fund schemes instead of availing the research services of professional stock brokers. This is being proposed so that the bringing of brokerage and transaction cost under the TER limit does not discourage fund managers from churning the portfolio in the interest of investors.
Observation 2: SEBI observed that additional expenses charged by AMCs for B-30 cities are not charged to all schemes uniformly. It stated that B-30 charges are often not included in schemes where the AMCs intend to keep a low expense ratio. This incentive is often used as a mechanism to promote one scheme over another by showing lower expenses instead of consistently encouraging financial inclusion.
Proposal: In this regard, SEBI has proposed that the distributors may be paid only for investment/inflows from new individual investors (new PAN) from B-30 cities at the industry level. Such additional commission may be fixed at 1% of the size of the first application or amount committed through the SIP of the individual investor at an industry level, subject to a maximum of Rs 2,000. The cost of distribution commission for inflows from B-30 cities, which results in financial inclusion, may be paid from investor education and awareness expense charged to the scheme.
Observation 3: Earlier, SEBI had mandated that the exit load charged to investors exiting from a scheme should be credited back to the scheme. The intent behind the said amendment was that early redemptions by investors from the scheme have an impact on the non-exiting investors and thus, they should be compensated by crediting exit load to the scheme. In that context, AMCs were allowed to charge additional 20 bps as an additional expense to the scheme, which was later reduced to 5 bps. According to SEBI, in FY 2021-22, while the total amount of additional expenses charged to the schemes was Rs 735 crore, the exit load recovered from exiting investors and credited to the schemes was around Rs 611 crore.
Proposal: In view of the above and considering that for more than 10 years AMCs have been permitted to charge additional expenses, SEBI has proposed that the provision enabling charging of additional expense of 5 bps for schemes having provision of exit load, maybe discontinued.
Observation 4: SEBI noticed that while the TER slabs are presently based on the AUM of the schemes, the AMCs enjoy economies of scale which are 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.
Proposal: Under the proposed changes, SEBI is of the view that the TER slabs should be at the AMC level and not at the scheme level. In this regard, 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).
Observation 5: At present, AMCs are permitted to deduct transaction charges of Rs 100 for existing investors in a Mutual Fund and Rs 150 for the first-time investor in Mutual Fund per subscription of Rs 10,000/- and above from the subscription amount of the investor. The amount deduced as transaction charges is paid to the distributor.
Proposal: In view of the overall proposal that all expenses should be included in the prescribed TER and considering that the distributors being agents of AMCs, should be entitled to remuneration for services rendered only from AMCs, SEBI has proposed that payment of upfront commission by the investor directly and transaction costs deductible from investments of investors, may not be permitted.
Observation 6: International Funds with large AUM have a low-cost structure, and thus Indian AMCs are often left with less room to charge desired TER for managing investments in such international Fund of Funds (FOFs). Further, AMCs are also required to pay licensing fee for using an overseas benchmark. Thus, it leads to relatively high-cost International Funds being sold to Indian investors instead of low-cost efficient funds, which is not in the best interests of investors.
Proposal: For schemes investing only in International Funds, SEBI has proposed that the TER over and above the weighted average of the TER of the underlying scheme(s) shall not exceed higher of two times the weighted average of the TER levied by the underlying scheme(s) and the actual cost of running a scheme including distribution commission of not more than 50 bps but excluding AMC management fees, subject to the overall regulatory limit.
Observation 7: The data on redemption of mutual fund units during FY 2021-22 shows that around 77% of the total mutual fund units were redeemed within two years of investment, while in FY 2022-23, 73% of units were redeemed within two years of investment. Only investment in 3% of the units continued for more than 5 years.
Proposal: To discourage churning/mis-selling by distributors, SEBI has proposed changes as under:
a. In case of switch transactions, the distributor will be entitled to lower of the commissions under the two schemes of any switch transaction.
b. Mandate one of the following:
i) The commission to the distributor should be in increasing trend with the first year’s commission not exceeding more than 25% committed to the distributor for the first three years,
ii) The commission paid to the distributor should be equal for all years.
Observation 8: AMCs can charge high exit loads even when a scheme does not perform well, and the value of investment goes down. In this regard, SEBI observed that it cannot be denied that the early redemption by investors from the scheme has an impact on the non-exiting investors, and exit load discourages early exit from the scheme.
Proposal: In this regard, SEBI has proposed that Performance linked TER can be enabled for active open-ended equity schemes wherein AMCs can charge higher management fees if the scheme performance is more than an indicative return above the tracking difference adjusted benchmark (Tracking difference adjusted benchmark means benchmark returns adjusted for permissible operational cost of managing the fund).
Observation 9: The TER charged to investors is based on estimations, and actual expense may be higher or lower than the estimated cost. Consequently, if higher investment and advisory fees are charged to Regular plan as compared to Direct plan for the same service, it may not be in the interest of investors of Regular plan. The issue of difference in the actual and estimated cost charged to investors can be addressed by increasing the frequency of reconciliation of TER and crediting back the difference of accrued cost vs actual cost, if any, to the respective plan at the end of the financial year/fixed frequency, e.g. weekly/monthly.
Proposal: There should be uniformity in charging of each and every expense to the investor of regular plan and direct plan and the only difference between the TER of regular plan and direct plan should be the expenses towards distribution commission.
SEBI has also proposed that for schemes where investment of investors is under a lock-in or quasi lock-in (such as under ELSS schemes, Close-ended schemes, and also for Target Maturity schemes wherein investment is intended to be held till maturity to mitigate interest rate risk and getting projected yield on maturity), the TER may not be increased for the existing investors. Any increase in the TER of schemes (ELSS and Target Maturity Funds) may be applicable only for new investments, and the existing investments in such schemes shall be grandfathered. However, any such exit to investors or grandfathering of investments may not be required if the increase in TER of a Mutual Fund scheme is as per the regulatory requirement due to a change in AUM.
While the proposed changes are in the interest of investors, there could be various challenges in the implementation of the same. For instance, certain proposals like the performance-linked expense ratio could be especially troublesome to implement as it will require the AMCs to put in a provision to calculate the management fee to be charged for every investor at the time of redemption. Meanwhile, a few other proposals such as the inclusion of brokerage cost under the TER limit could affect the revenues of equity-oriented schemes.
SEBI has invited public comments on the proposed changes, and the deadline for submitting feedback is June 01, 2023.
This article first appeared on PersonalFN here