SEBI's Plan To Regulate Mutual Fund Expenses Will Benefit Investors: Here's How

Indian stock market Nifty 50 tripled in value from March 2012 to March 2023, a period of 11 years. While this was happening, the assets under management (AUM) in the mutual fund industry increased six-fold, growing from approximately Rs 6 lakh crore to approximately Rs 39 lakh crore.

By  March 31, 2023, there were  Rs 3.77 crore or Rs 37 million unique mutual fund investors, 2.94 times higher than on March 31, 2017 (Rs 1.28 crore or Rs 12.8 million). Investors have paid around Rs 30,000 crore under AMCs for managing their wealth in just FY22. This isn’t a small amount of money and obviously involves a large number of investors. 

The Securities and Exchange Board of India (SEBI) has a problem with the amount being charged and the way it's being charged. It plans to introduce a new system for mutual funds to collect fees for managing the money of mutual fund investors. This is important as the fees charged by mutual funds can eat up a significant portion of the returns that the investors receive. 

What does that mean? For example, if returns on a fund are 10% before excluding expenses and the fund’s total expense ratio (TER) is 0.5%, the return on the mutual fund reduces to 9.5%.  

There are certain expenses, called additional expenses, that are not included in TER. Hence the actual returns on mutual funds are even lower. If you started with an SIP of Rs 10,000 per month for 10 years then direct fund value will be Rs 19.72 lakhs and regular fund value will be Rs 18.62 lakhs on investment cost of Rs 12 Lakhs. The difference between both fund values is around Rs 1 lakh, a huge amount. That’s why TER matters.

While there are regulations to cap TER, there is no cap additional expenses. The SEBI wants to regulate this by implementing a new TER structure that will regulate all expenses. The SEBI also wants to link TER to how well a mutual fund performs. 

SEBI recently published a consultation paper on TER, proposing two significant changes to the mutual fund scheme framework.

1. TER should encompass all costs and expenses that were not included earlier. This includes GST on management fees, brokerage and transaction costs, and B-30 incentive. These revisions aim to enhance transparency and align the interests of AMCs with investors.
2. The TER should be determined at the level of the asset management company (AMC) rather than at the scheme level. The AUM of open-ended schemes, which currently follow slab-based TER, should be categorised into two groups: Equity-based AUM, comprising equity and equity-related instruments, and other than equity-based AUM, encompassing investments excluding equity and equity-related instruments.

What led the SEBI to propose these changes? How are AMCs charging more money to manage assets and how is it affecting investors? Let’s take a look. 

Choosing Between Regular and Direct Mutual Fund Plans

There are two options when investing in a mutual fund — the regular plan and the direct plan. The regular plan involves investing through a distributor who earns a commission. This commission is included in TER. However, the direct plan enables you to invest directly without involving intermediaries, in turn leading to a lower TER.

Both plans have the same portfolio and are managed by the same fund managers. The difference lies in their expense ratios and net asset values (NAVs) which basically means the price of mutual fund units. The regular plan has a higher expense ratio because of the commissions paid to the distributor, while the direct plan will have a lower expense ratio.

Choosing the direct plan will get you better returns by saving on the expenses of intermediaries.  

 

What Is TER?

The SEBI (Mutual Funds) Regulations, 1996, allow mutual funds to charge certain operating expenses for managing a mutual fund scheme such as sales and marketing/advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees, audit fees – as a percentage of the fund’s daily net assets.

All such costs for running and managing a mutual fund scheme are collectively referred to as TER.

TER is calculated as a percentage of the scheme’s average NAV. The daily NAV of a mutual fund is disclosed after deducting the expenses.

Currently, in India, the expense ratio is fungible. This means there is no limit on any particular type of allowed expense as long as the total expense ratio is within the prescribed regulatory limit. 

Presently, a slab based TER is applicable for various categories of schemes such as Equity Schemes, Debt Schemes, Hybrid Schemes and Solution Oriented Schemes.

Here are the existing slab-wise TER limits for open-ended equity oriented and other than equity-oriented schemes:

What Are The Problems In Current TER Mechanism?

1: No capping on additional expenses: A comparative analysis was conducted by the SEBI on the weighted average base TER and the actual total TER charged to unitholders of open-ended equity schemes during the financial year 2021-2022.  

It found that in the case of regular plans, where there is no upper cap on additional expenses (brokerage, B-30 Incentives, exit load and GST). The actual expenses incurred by investors were also significantly higher than the prescribed base TER limits (as shown in column G). 

However, in direct plans, the cost of investment, including all additional expenses, remains well below the regulatory limits. This highlights the potential cost savings for investors who opt for direct plans, as they can benefit from lower expenses compared to regular plans.

In the proposed TER, the revised slabs proposed for equity-based AUM of schemes at the AMC level incorporate higher TER limits to encompass all costs and expenses, including GST on management fees. This means new TER limits will include additional expenses and will be capped.

In addition, TER slabs for AUM invested in instruments other than equity and equity-related instruments, excluding AUM of overnight schemes, are proposed as follows:

TER-related proposals are summarised below:

 

2: No link between TER and performance benchmark: According to the current norm, regardless of a scheme's performance compared to its benchmark, asset management companies levy management fees and expenses. An evaluation of performance data of active schemes over different time frames (1 year, 3 years, 5 years, and 10 years as of February 2023) reveals the following findings:

It is evident from the analysis that regular plans of schemes exhibit greater underperformance compared to direct plans.

How to read this data? For example, during the 1 year period, 25.75% of regular schemes and 17.23% of schemes underperformed benchmarks by more than 1.25%.

However, it is important to note that substantial underperformance of a fund compared to its benchmark is not beneficial for the unitholders. On the other hand, AMCs that outperform the market may consider implementing a performance-linked TER. Therefore, the idea of introducing a variable TER based on scheme performance is worth exploring

3: Switch Transaction: With higher distributor commissions in new schemes, companies and distributors start selling the new fund offerings and ask investors to switch from the existing scheme to the new scheme.

The data for FY2021-22 indicates that approximately 71% of the total mutual fund units were redeemed within two years of investment. Similarly, in FY2022-23, approximately 73% of units were redeemed within two years. It is noteworthy that investments in only 3% of the units persisted for a duration of more than five years.

This is because higher commissions are often given to distributors for new fund offer (NFO) schemes, resulting in switch transactions from existing large AUM schemes that typically have a lower average TER to NFO schemes with a higher TER.

To change such practices, SEBI proposed AUM based TER at AMC level. 

It is important to address certain issues, such as the need for improved transparency in the TER framework, introducing performance linked TER and minimising switching transactions that are detrimental to investors.

It is crucial to continue fostering this momentum while promoting investor education and implementing regulatory measures that benefit the investors in the long run.

What’s the impact of the revised TER structure?

SEBI says the revised changes will lead to reduction in expenses investors pay to AMCs by 4.55%.

The table below shows the impact of TER at AMC Level

Equity oriented schemes:

For example, State Bank of India’s (SBI) current weighted average TER is 1.80% while maximum proposed TER will be 1.63% leading to reduction in TER by 0.17% points & by -9.44%. There are 17 out 19 equity schemes of SBI AMC that have excess TER in comparison with the proposed TER.

Almost all AMCs will be negatively impacted but there are some outliers where there will not be impact in equity schemes like PPFAS, Motilal Oswal etc.

Debt oriented schemes

How 2019 TER cut impacted AMCs?

In 2019 also, SEBI implemented similar TER cuts. “The last round of TER cut saw AMCs being able to pass on a major share (~75-90%) of the impact, largely to the distributors. This time, however, given the inclusion of GST, trading cost and STT will mean that the impact will have to be shared with brokers as well.” said Kotak Institutional Securities. Similar to last time, AMCs are confident of passing the majority impact of TER hit to brokers and distributors.

It will be interesting to see how changes in mutual regulations will empower investors in the long term, enabling a larger population to financialisation of savings.