A cashier examines Indian rupee banknotes at a bank in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Panel Suggests To Link Mutual Fund Fees To Performance, Assets

A panel set up by the market regulator found there’s room to reduce expenses paid by investors of equity mutual fund schemes. It also suggested that fund houses should be barred from paying upfront fees to distributors to prevent mis-selling.

The committee said the Securities and Exchange Board of India could reduce the total expense ratio by either linking it to performance of the scheme or by lowering expenses as assets under managements increase, according to a report submitted on Sept. 4. BloombergQuint reviewed a copy of the document. Emailed queries to SEBI on the Mutual Fund Advisory Committee’s report remained unanswered.

This will be the second major review of expenses in six years amid a debate on whether Indian mutual funds charge too much. Morningstar in its October 2017 report said India’s average equity expense ratio at 2.22 percent is among the highest in the world. But the Foundation of Independent Financial Advisors, in a separate report, countered that at 1.88 percent, the ratio is the lowest among developing nations.

In 2012, the regulator had allowed fund houses the freedom to charge expenses as they deemed fit provided they remain below a cap of 2.5 percent of assets under management. The industry, on an average, charges up to 2.50 percent.

This is how the panel suggested they can be lowered:

Linking Expenses To Performance

The panel found that from 1.05 percent prior to 2012, the average management fees for equity schemes increased to 1.38 percent as of March this year. That compares with 0.48 percent for debt schemes.

“It appears that the revenue from equity schemes is compensating the cost of debt schemes,” the committee said in the report. Mutual funds pass on any gain or loss to investors, it said, and they charge expenses and management fees whether they are performing or not.

According to the panel’s proposal, investment management fee portion of expenses will be linked to performance of the scheme, while the rest won’t change. The scheme lagging the benchmark returns will have to lower the expense ratio. And scheme performing better than the benchmark can increase expenses to 3 percent of the assets under management, the report said.

Here’s how it works:

Pros: An investor will be happy to pay higher fees if he is getting a better return than the index, said a fund manager of a small-sized fund house who didn’t want to be identified as the policy is yet to be made public. This, he said, will make fund managers more accountable.

Cons: The chief executive officer of a medium-sized fund house, who wished to remain anonymous, said the fear of underperformance will increase undue risk as fund managers will try to beat the benchmark or replicate an index.

Fees Based On Asset Slabs

The panel suggested that the maximum total expense ratio for equity schemes should be reduced. And it proposes to target the ones with higher assets under management.

Of about 583 equity and balanced schemes, 155 managing assets of more than Rs 1,000 crore contribute more than 87 percent of the total average assets under management.

Here’s what the panel recommends:

If the new expense structures are not followed, the fund houses will be barred from launching new closed-ended equity schemes, according to the panel’s report.

For passive funds such as index funds and gold exchange-traded funds, it suggested the expenses should come down from 1.5 percent to 1 percent.

A CEO of a large sized fund house said in the present scheme of things, there is hardly any scope to reduce expenses. But if the slabs are tweaked, then industry may be able to bring down the expenses, the person said.

Bar On Upfront Commissions

Fund houses pay distributors commissions either upfront from their books or from the scheme based on investments by clients (also called trail commission). From 11 percent in 2009-10, the panel found that the payout from books doubled to 22 percent in 2017-18.

To prevent unnecessary churning of portfolio and mis-selling, the report said all commissions must be paid from the scheme by asset management companies. And, it said, “no upfront commission should be paid to distributors directly or indirectly in cash or kind”.