SEBI proposal on MF TER is better for investors, but implementation complex

Last month Securities Exchange Board of India (SEBI) has made some proposals that would enhance the way investors benefit from investing through mutual funds (MF). The consultation paper largely addressed on how the expenses are charged to the investors, by trying to further bring regulations and thus provide level-playing field to all the asset management companies (AMCs). The paper was titled, “consultation paper on review of Total Expense Ratio (TER) charged by AMC to unitholders of schemes of MF to facilitate greater transparency and accrual of benefits of economies of scale to investors”.

The 40-page document is exhaustive and tried to address multiple aspects of the expenses that investors end up paying or charged by the AMC for investing in their funds. The framework of TER has been reviewed and certain proposals have been made keeping in view the following guiding principles:

i. Transparency in total expenses charges to investors

ii. Accrual of benefit of economies of scale to investors

iii. Encourage new participants/AMCs

iv. Facilitate financial inclusion

v. Removing dual charges, if any, to investors

vi. Addressing the likelihood of proliferation of schemes due to scheme level TER

vii. Addressing the issue of splitting of applications, churning of investors portfolio etc., for higher distribution commissions

Performance based TER: This is probably the most disruptive proposal in the entire document released by the regulator. The current practice is, irrespective of the performance of the scheme (relative to benchmark) the AMCs are charging the management fees and expenses on a daily basis. The consultation paper is exploring the possibilities in two ways to implement this.

Paper says, “To start with, performance linked TER can be enabled for active open ended equity schemes wherein AMCs can charge higher management fee 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 operating cost of managing the fund). Alternatively, AMC can be permitted to charge higher management fee based on a pre-decided hurdle rate as may be disclosed in the SIDs. Such higher management fees under both models can be either at fixed rate or on returns sharing basis.”

Approach A: During the period in which the investor remains invested, the base expense ratio may be charged to the investor. At the time of redemption, the management fees may be charged if return of more than indicative rate is generated or annualized returns by the investor is above the hurdle rate.

Approach B: There can be another approach where higher expense limit for performance-based TER may be fixed and TER inclusive of management fees is charged to the investor. The TER charged by the schemes in such cases should be based on the scheme’s performance during the previous year. At the time of redemption by the investor, if AMC fails to generate return above the indicative returns for investor or the annualized returns for the investor is below the hurdle rate fixed in advance, the AMC may retain base TER as may be applicable and return the remaining expenses charged.

The proposal on the face of it is interesting and serves the investors’ interests, but the implementation is a bit complex. The approach A seems to be simpler, but the timing of redemption is always arbitrary.

Switch Transactions and Distributor Commissions: The data analysis done by SEBI shows that majority of commission garnered by new scheme is from switches. In one of the schemes, up to 55 per cent of the fund garnered in NFO (New Fund Offering) was through switch transactions from other schemes of the MF. This is another widely practiced or misused distributor provision as the new scheme (mostly a lower asset would pay off a higher commission, though up-front income was abolished) would earn them a higher commission.

To counter this, SEBI has proposed that in such cases, the commission would be lower of the two schemes and the commission to the distributor should be increasing trend with the first year’s commission not being more than 25 per cent paid to the distributor should be equal for all years.

Review of slab wise TER structure: The current slab wise TER structure, based on the assets under management (AUM i.e., fund size) has been specified to enable passing of the benefit of economies of scale achieved by the AMC to the investors. But, study by SEBI found that the economies are being enjoyed by the AMC are linked to the asset levels and not schemes. Their finding that the manpower for research and other core activities of the AMCs may be different for equity and debt products but every new scheme doesn’t necessarily attract additional spending towards these activities of the AMCs.

SEBI’s proposed that the TER slabs should be at the level of the AMC and not at the scheme level. The current scheme-based TER may be bucketed into equity based AUM.

TER limits of all expenses and charges: Currently MFs are permitted to charge four additional types of expenses over and above the specified TER limits, viz.,

• Brokerage and/or commission paid for transactions in the securities held

• An extra expense for exit loads

• GST on investment and advisory fees

• Extra brokerage for the B-30 cities

The consultation paper states that the total expense ratio should bring transparency and inclusiveness to imbibe all the expenses charged to the investor at any point of time. However, the current practice is over and above the existing TER and thus present an ambiguity in the manner in which the unitholders are charged. SEBI proposes that the word “Total” should mean in principle and literal. Accordingly, makes recommendations and observations in each of these areas.

(The author is a co-founder of “Wealocity” and could be reached at [email protected])