Are mutual fund expense ratios too high for retail investors?

It is in this context that the Securities and Exchange Board of India (SEBI) in December commissioned a detailed study on the existing policies and market practices of charging investors on TER. Recent reports suggest that the regulator may propose the introduction of a uniform expense ratio across all fund schemes.

To be sure, as per the current framework, there is a cap on the expense ratio on the basis of assets under management (AUM) of a scheme. In case of open-ended equity and debt schemes, the maximum TER charged by the fund house is 2.25% and 2% respectively on regular schemes. As the AUM of the scheme increases, the applicable TER tends to come down. The idea is to pass on the benefits of economies of scale to investors.

If the proposed uniform TER becomes effective, all equity/debt mutual fund schemes will be subject to the same expense ratio cap. Its objective is to discourage the increasing number of schemes in the mutual fund industry and to prevent mis-selling of schemes. There are reports that SEBI has noticed some distributors who are inducing investors to invest money from existing schemes in New Fund Offers (NFOs), which generally come at higher expense ratios and thus higher returns. Attract commission.

Besides this, reports also suggest that the regulator may bring GST (Goods and Services Tax) and transaction charges – on buying and selling of securities in the portfolio – under TER. These are currently charged to an investor over and above the TER.

In addition, AMCs may also charge an additional 30 basis points (0.3% of AUM) for retail applications. 2 lakh from B30 cities (locations beyond the top 30 geographical cities in India). This is to encourage distributors to bring in customers from B30 cities. However, Sebi has temporarily barred fund houses from charging additional charges for B30 retail properties, citing inconsistencies in implementing the B30 norms.

SEBI’s recent statement on this said that it has taken note of mis-selling practices by distributors at B30 locations including splitting of transactions. 2 lakh limit) and churning out existing investments for reinvestment for higher commission.

Here are some statistics related to the increasing number of schemes in the mutual fund industry year-on-year, Top fund houses with large AUM charge higher expense ratios, and Asset Management Companies (AMCs) charge higher commission to distributors on equity schemes. pays.

increasing number of plans

Mutual funds in India offer a wide range of schemes to the investors. As on date, there are around 1,284 schemes which include equity, debt, hybrid and others, both active and passive funds which are open-ended. In 2022 alone, around 194 schemes were launched and these were dominated by inactive schemes under both equity and debt. In about five years now, the number of mutual fund schemes has increased at about 13% CAGR (Compound Annual Growth Rate).

Santosh Joseph, a Bengaluru-based mutual fund distributor, said, “If the reports are correct, then by introducing a uniform expense ratio, SEBI wants to make the structure more rational considering the operational efficiency of the AMCs.” ,

“When the AUM size of the AMC increases, the same team can continue to manage multiple schemes. Why should there be a different expense ratio for NFOs when the fund manager, key management personnel, operations team and sales team across schemes are all mostly the same? Uniform expense ratio in new and old schemes discourages unwanted proliferation of schemes,” said one of the persons associated with the mutual fund industry, who did not wish to be identified.

With a similar expense ratio, distributors, too, would have no incentive to force investors to invest in NFOs by redeeming their money in existing schemes.

However, not everyone is in favor of the proposal. Some argue that a similar TER may not bring the desired result. “Instead, why not cap the commission paid to distributors on NFOs” and “put a cap on the number of schemes a fund house can launch”, are some of the views that are against the same expense ratio.

high expense ratio

Since the rationalization of SEBI’s expense ratio structure in 2018—when TER rates and slabs were changed—the yields of large AMCs have fallen. The yield of the AMC represents the fee collected from the investor as a percentage of the value of the investment. As their AUM grew, fund houses had to reduce the expense ratio to comply with TER norms.

“AMCs were affected by lower total expense ratio (TER), as mandated as per SEBI directive. As a result, the yield on AUM for the top 10 players declined from 69 basis points (bps) in FY18 to 48 bps in FY22,” according to a report on the mutual fund industry written by Mohit Mangal from BOB Capital Markets. A basis point is one hundredth of a percentage point.

Having said that, the revenue of large AMCs has grown at a healthy rate over the years, with the AUM of the industry now almost doubling as compared to 2018. Most of the large AMCs have seen an increase in PAT (Profit After Tax) due to reduction. in the potential costs behind economies of scale.

However, 15-50% equity schemes offered by large AMCs with huge AUM still carry a high expense ratio of more than 2%. Most of the loan-oriented schemes charged TER much less than the maximum permissible limit.

Still, any drastic change could adversely affect the mutual fund industry, which is already highly regulated, opine those in the industry.

“Any rationalization of expense ratio on the equity side could be a retrograde step for the sector,” said an industry veteran.

Bringing GST and transaction (brokerage) charges under the ambit of TER is going to have a huge impact on the profitability of companies, according to the industry. Another industry representative said, “Any cap on transaction fees will hamper the fund manager’s ability to transact.”

high commission

In view of the high number of NFOs launched in 2021 and 2022 amid a buoyant equity market, the commission paid by fund houses to distributors increased in FY22, as mentioned in the BoB Caps report mentioned earlier. “At the industry level, commission payments increased to 77 bps at the end of FY22 as compared to 66 bps in the previous year,” the report said.

There have been instances of smaller AMCs paying more than three-fourths of the fee collected from investors as distributor commission (see graphic) on their equity schemes. Such high commissions can be a cause of concern for the regulator as it can lead to conflict of interest when fund houses chase high AUM.

Industry experts believe that a cap on brokerage commission as a percentage of TER can be a solution to this problem.

conclusion

With the mutual fund industry registering an impressive growth in AUM since 2018, it is perhaps time for SEBI to re-look at the expense ratio structure of mutual funds.

The measures that the regulator may bring in could have a long-term impact on the returns that would be earned by mutual fund investors and improve the industry ecosystem.

According to experts, SEBI’s move to reduce the expense ratio in 2018 and ban advance commission to distributors has had a positive impact on the industry over the years.

Measures aimed at preventing new schemes being launched to inflate AUM and regulations enabling the benefits of economies of scale for investors are now necessary.