BACKGROUND

On May 18, 2023, the Securities and Exchange Board of India [“SEBI”] had placed a consultation paper related to the total expense ratio charged by Asset Management Companies [“AMC”] to unitholders of mutual funds. June 8, 2023 was set as the deadline for submission of public comments. The due date, however, was extended to June 8, 2023.

The proposal is aimed at curbing distributor practices such as unnecessary switching of schemes and pushing new fund offerings for higher commissions. SEBI in its consultation paper proposed to introduce performance fees for funds. It proposed two approaches, but also suggested testing the models under the Regulatory Sandbox.

KEY PROPOSALS

1. All-Inclusive Total Expense Ratio[“TER”]: The regulator has proposed that the Total Expense Ratio should be inclusive of all expenses and reflect the maximum expense ratio that investors may have to pay at any point.
2. Limited Membership: For executing their own mutual fund schemes, AMCs should be allowed limited stock exchange membership.
3. Slabs at AMC level: The paper suggests that TER should be charged at the AMC level and not at the level of the scheme.  
4. Revised TER slabs: The paper proposes separate slabs for equity and non-equity instruments. For an equity scheme, 2.55% is the maximum TER that can be charged at the AMC level. This cap is available to AMCs that fall under the first AUM slab of up to INR 2,500 crore.
5. B-30: Distributor may be paid additional commission from B30 cities only for investments from new individual investors (new PAN) at the industry level. AMCs can take into account a higher percentage of commission for investments from B-30 (beyond top 30) cities, against commission for inflows from T-30 (top 30) cities. 
6. Performance-based TER: SEBI has proposed the concept of variable TER based on the performance of schemes. If the scheme performance is more than indicative return above the tracking difference adjusted benchmark, AMCs may charge higher management fees, or they may base their higher management fees on a pre-determined hurdle rate that may be disclosed in Scheme Information Documents.  
7. Switch Transaction: In case of a switch transaction, the lower of the commissions offered under the two schemes will be charged.
8. Inclusion of Women: The paper provides for additional incentive for distributors for new investments from women investors (new PAN) at the industry level.

ANALYSIS

An all-inclusive TER will mean that all brokerage and transaction costs of trading, which mutual funds typically charge for buying and selling of stocks or bonds will be a part of TER. From a mutual fund’s perspective, these suggestions may have significant impact on certain categories of schemes. A case in point is Arbitrage category. An arbitrage fund is continuously buying and selling stocks. Hence, they have a high churn ratio. Therefore, for arbitrage and other similar categories, TER will shoot up. From an investor’s perspective, an inclusive TER will result in churn reduction, lessening of unwanted trades and more transparency.

The proposed charge structure is at a category level, which is further bifurcated into equity and non-equity instruments. This move is likely to bring in further transparency because when the sum of all equity holdings of a particular AMC is added and then slabs are placed, the overall charge structures will become fairly uniform irrespective of whether a new scheme is launched or there is mobilisation in an existing scheme.

The suggestion for switch transactions would disincentivise distributors from switching. As per SEBI, from April 2021 to September 2022, around Rs 85,000 crore were raised during NFOs, of which 27 percent came from switch transactions. The switches were made because NFO was offering higher commission and hence, switches were made from existing schemes, which were at lower rate of trail commissions. Against this backdrop, SEBI’s suggestion will result in seizing of new inflows which were earlier happening because of higher commission.

With regard to the impact of the suggestions on smaller AMCs, there exist two viewpoints. Some believe that adoption of the proposals would give smaller AMCs an edge and hence, will result in their better performance. The other viewpoint is that just because smaller AMCs will charge higher expense ratio as compared to larger AMCs, bigger institutional flow would be towards bigger economies because of margin of economies. The basic objective behind a slab wise expense ratio is to benefit smaller AMCs, but it is possible that larger AMCs might keep on attracting volumes and the smaller AMCs would continue to remain loss making.

In a retail construct like mutual fund, performance-based TER can be difficult to execute. However, the fact that SEBI has proposed the model to be tested under a regulatory sandbox is a thoughtful move. In a sandbox like environment, AMCs will be more open to experimenting, which will lead to fair results. 

CONCLUSION

SEBI’s consultation paper is a landmark step toward ensuring transparency, reducing inefficiencies and curbing prevalent malpractices. It makes mutual fund expenses true to label, which means whatever is shown to the investor is actually getting charged to the investor. Adoption of the regulations would result in cheaper investments and less churning. The accrual of the benefits of the economies of scale would pass to the end customer.

Today, a lot of schemes do not charge maximum TER. These suggestions might lead to AMCs resorting to increasing the costs of all schemes to maximum permissible limit, which would impact some of the debt investors. Implementation of these suggestions may result in consolidation in the mutual fund industry. The industry may also resort to having lesser schemes rather than a larger basket of schemes, which share similar approaches to investing.