Tuesday, 13 June 2023

Reining in TER (Total Expense Ratio) Vs. Profitability of Mutual Fund Schemes

Lately, SEBI has issued a Consultation Paper for reviewing TER (Total Expense Ratio) charged by AMCs (Asset Management Companies) to unitholders of schemes of Mutual Funds. The aim is to facilitate greater transparency and accrual of benefits of economies of scale to investors. 

The basic objective of Mutual Funds is to extend the benefits of expertise in investments to common public specifically to those who don't have large capital to invest and who don't have adequate knowledge of the working of financial instruments. These Mutual Funds are usually managed by AMCs  who take the money from the investors by selling Mutual Fund units and invest them in different equity or debt instruments and then hand over the major chunk of profit generated by this to unitholders. As this requires significant application of expertise they charge their fees in form of Expense Ratio over and above Entry Load (now not charged in India), Exit Load and Transaction Charges. 

For saving the usually less aware investors (unitholders) from the whimsical amounts in the name of charges of AMCs, SEBI has put a cap on the Expense Ratio since long. But even in this framework some of the expenses have been kept aloof from this capping clause so far. Such charges are -

i. Brokerage and transaction costs (up to 0.12% for cash and 0.05% for derivatives)

ii. Expenses not exceeding 0.30% of daily net assets subject to net inflows from B-30 cities

iii. Additional expenses not exceeding 0.05% of daily net assets for the schemes having Exit Load

iv. GST and advisory fees 

It is worthy to mention here that there is no upper cap on additional expenses as a whole.

But the Mutual Fund industry has grown significantly over the last few years with considerable increase in participation of retail investors. Hence the concerns existing at the time of introduction of additional expenses over and above the TER may not hold true today keeping in views of economies of scale. Moreover, since there is ambiguity and lack of transparency in the manner in which unitholders are charged by different Mutual Funds. In the view of SEBI, it is desirable that TER reflects the maximum expense ratio that an investor may have to pay and hence it should be inclusive of all the expenses permitted to be charged to an investor and investor should not be charged any amount over and above the prescribed TER limits. And the recent Consultation paper of SEBI has proposed to implement the same.

As in the extant provisions, AMCs are already allowed to become a proprietary trading member for carrying out trades in the debt segment of the recognised stock exchange on behalf of its mutual fund schemes and are also permitted to become a self-clearing member of the recognised clearing corporations to clear and settle trades in the debt segment on behalf of its mutual fund schemes. As SEBI intends to bring the brokerage and transaction cost within the TER limits (and not charged over and above it as of now) there is a likelihood that this may reduce some profit of AMCs for increasing the profit of unitholders. So something must be done to lessen the expenses of AMCs too. This is proposed to be done by allowing them to exercise their option of obtaining limited purpose membership with stock exchanges for carrying out trades in both debt and equity segments. This step will help them to reduce expenses towards brokerage and transaction cost. As this step is a win-win for both AMCs and unitholders so undoubtedly a welcome step.

For promoting inclusiveness of Mutual Fund schemes it is desirable that there should be more incentives to the distributors working in smaller cities namely B-30 cities i.e. cities other than the top 30 cities in India. Though it looks a benign provision which actually serves the motive of addressing the right of equality in financial investment of comparatively interior areas of India, the problem arises when it is misused. Investment amounts higher than INR 2 lakhs (threshold for classification as retail investment) are often split to make each application for investment of less than INR 2 lakh so that B-30 expenses can be charged. Also in many cases, investments of B-30 investors are often churned by way of withdrawal and re-investment after a year (One year is the minimum holding period requirement). Moreover the varying methods of computing additional expenses for inflows from B-30 cities and charging of expenses based on projections rather than actuals add to lot of confusion. So, if the distributors are paid B-30 expenses for investments from only the new individuals (PAN) added as proposed then it must reduce the malpractice of churning by way of withdrawal and re-investment every year just to avail the expense benefit. Also, the proposal of charging of expenses on actuals and not on projected figures is well-appreciated. The additional commission is proposed to be fixed at 1% subject to a maximum of INR 2000/-.

Exit Load is allowed to AMCs in case of early redemption by investors. The intent behind the said amendment was that early redemptions by investors from the scheme has impact on the non-exiting investors and thus they should be compensated by crediting exit load to the scheme. AMCs can presently charge additional 5 bps (basis points) i.e. .05% of daily net assets due to credit of any exit load to the scheme. The said additional charge was allowed for schemes where SIDs (Scheme Information Document) have a provision of charging of exit load. But here SEBI found that AMCs can charge additional 5 bps to the scheme even if there is no claw back/ exit load credited to the scheme. So, it has proposed that this additional expense of 5 bps should be discontinued. Some people say, rather than discontinuing it, this expense should be allowed on the actual amount of exit load charged and credited to the schemes. By this, they think, the purpose of safeguarding the interest of non-exiting investors would be served more accurately.

GST (Goods and Service Tax) on investment and advisory fees is presently charged over and above the specified TER limits which is proposed to be brought under the new TER limit which will be fixed after a suitable adjustment for removing a probable significant impact for change in this provision. Here, it is not clear why the matter is being complicated if SEBI has no objection in allowing GST  on investment and advisory fees over and above the present TER limit.

As per the extant provision, a slab wise TER structure in the MF Regulations has been specified for passing of the benefit of economies of scale achieved by AMCs. It means, higher the AUM size, lesser the limit of TER. The proposal is that TER slabs should be at the level of the AMCs and not at the scheme level. The reason behind this is to avoid switch transactions from existing large AUM schemes to NFO schemes of the same AMC where higher TER can be charged. The bucketing of Equity based AUM and and other than equity based AUM of the AMC is likely to be useful considering the skill set required for analysing and taking decision of investments for equity & equity related products is different from the skill sets required for other than equity related products.

Revision of TER limits is a core proposal of this consultation paper and all the expenses will have to be brought under this TER limit in the new regime. This is vital to revise it adequately so that AMCs should not feel discouraged for applying their best mind and efforts in favour of maximum return to the unitholders. The four additional expenses allowed at present over and above the TER till now will come under the overall limit of revised TER. These expenses are (i) Brokerage and transaction costs which is 0.12% of cash trade and 0.05% of derivative transactions, (ii) Expenses not exceeding 0.30% if daily net assets subject to the inflows from B-30 cities, (iii) Additional expenses not exceeding 0.05% of daily net assets for the schemes having provision of exit load and (iv) GST on investment and advisory fees charged by Mutual Funds/ AMCs.

All of the above expenses will be just a part of overall TER limit after the implementation of new provisions. If the new slabs from 2.5% to 1.3% (for equity oriented instruments) and 1.2% to 0.9% (for other than equity related instruments) had been implemented in FY 2021-22 then the expenses charged had been fallen down from INR 30,806 crores to 29,404 crore lessening the impact by 4.55% at industry level.

Though the weighted average method for hybrid schemes and glide path for AMCs seem to be fine the overall limit of TER may better be fixed after taking the AMCs in confidence since the ultimate return depends on their efficient working and not on regulatory limits on expenses they incur. This is particularly significant in equity oriented schemes.

Other proposal includes disallowance of upfront commission by investor directly to distributors and transaction costs deductible from investments of investors which seems well.

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 FOFs. Futher, AMCs are also required to pay licensing fees for using an overseas benchmark. Thus, for avoiding 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 it is proposed that the TER shall not exceed higher of two times the weighted average of the TER levied and the actual cost of running a scheme including distribution commission.

To discourage churning / mis-selling by distributors it is proposed that the distributor shall be entitled to lower of the commissions offered under the two schemes of any switch transaction which is fine. The lowering of maximum permissible limit of exit load from 5% to 2% is also proposed. As this will fall under presumably under the overall limit of the new TER any overthinking on it seems futile.

Performance based TER is also being explored and to start with, 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. Alternatively, AMC can be permitted to charge higher management fee based on a pre-decided hurdle rate. The maximum management fees may also be specified to discourage fund managers from taking imprudent risk in order to earn higher fees. Though it has been asked by SEBI whether to make performance based TER mandatory or voluntary, the more effective way seems to be making it voluntary. Even though they opt for higher TER based upon their performance the upper cap as mentioned above will save investors from reckless risk-taking propensity.

Additional incentive for inclusion of women investors in Mutual Funds is a welcome step. The grandfathering clause (a provision in which an old rule continues to apply to some existing situations while a new rule will apply to all future cases) seems to be well-intentioned to safeguard the existing investors in ELSS (Equity Linked Saving Schemes), Close Ended schemes and Target Maturity scheme. Yes, it would be just to investors to exit without exit load (as proposed) in case the TER limit is going to increase in their case.

Regular plan and Direct plan are virtually the same after they are bought the only difference being at the time of buying the distribution commission is charged to the investors in case of Regular plan. Therefore, it is but logical that there should be uniformity in charging of each and every expense to the investor of regular plan and direct plan (other than distribution commission).

Putting all the points succinctly it can be said that the proposals mentioned in the consultation paper of SEBI are well-intentioned and seem pragmatic. Though at the same time the ultimate aim should be to ensure enhanced profitability of the working of AMCs by way of tight monitoring and inspection. Needless to mention that even lessening chargeable expenses will have no meaning if AMCs don’t apply their best efforts for ensuring the best returns possible.

Author- D Hemant Kumar 
Email- hemantdas2001@gmail.com
Disclaimer: The author is not a Mutual Fund expert and the views expressed in this article is based on his personal understanding and perception over the consultation paper issued by SEBI.

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Reining in TER (Total Expense Ratio) Vs. Profitability of Mutual Fund Schemes

Lately, SEBI has issued a Consultation Paper for reviewing TER (Total Expense Ratio) charged by AMCs (Asset Management Companies) to unithol...