SEBI proposes a re-examination of expenses charged to mutual fund investors

The Securities and Exchange Board of India (SEBI) has released a 40-page consultation paper suggesting several modifications to the total expense ratio (TER) imposed on mutual fund investors. The paper is currently in the consultation stage and awaiting industry participant feedback. It covers 15 different topics for consultation.

As part of the proposed changes, the market regulator has recommended that the TER be calculated at the asset management company (AMC) level instead of the scheme level. SEBI believes this approach would foster increased competition, support smaller AMCs, and enable the transfer of cost efficiencies achieved through economies of scale to the investors.

SEBI has further proposed the concept of a performance-based TER and presented two approaches for consideration. However, the market regulator suggests these new concepts should be initially tested within a regulatory sandbox structure. This approach allows for controlled experimentation and evaluation before implementing them on a wider scale.

Additionally, the regulator has reviewed the existing framework of TER charges, which is based on the assets under management (AUM) slab-wise structure. This structure determines the TER charges based on the size of the assets managed by mutual funds.

Under the proposed new framework, SEBI has suggested that the maximum TER that can be charged for an equity scheme at the asset management company (AMC) level is 2.55%. This limit applies to AMCs falling within the first assets under management (AUM) slab, which includes funds with AUM up to ₹2,500 crores.

SEBI has slightly increased the maximum permissible TER rate from 2.25%. This adjustment has enabled the mutual fund industry to accommodate the GST expenses incurred on investments and advisory fees. The increase in TER allows the industry to absorb these additional costs effectively.

All charges within TER

SEBI intends AMCs to include all additional expenses within the TER to promote transparency and uniformity. The regulator has expressed concerns regarding AMCs charging brokerage and transaction charges to mutual fund schemes as additional expenses. SEBI has observed instances where trades were executed through brokers who were not among the top in gross turnover percentage share. These brokers often offered their services at high brokerage costs compared to other empanelled brokers. The regulator highlights that the high transaction cost for research reports cannot be considered a soft dollar arrangement. This implies that investors would end up paying twice for the research as part of the investment management and advisory fees and as brokerage and transaction costs.

SEBI has even proposed allowing AMCs limited membership of stock exchanges to cover transaction costs. This addresses concerns that TER-level limits may discourage portfolio changes for the benefit of investors.

The consultation paper states that since AMCs already charge management and advisory fees for managing scheme assets, which should ideally cover the cost of research for asset/securities selection, it is difficult to comprehend why substantial expenses related to brokerage and transaction costs need to be separately incurred by fund houses and passed on to investors under the guise of research. This practice not only leads to double charging of unitholders but also encourages undesirable practices that can affect the interests of the unitholders.

SEBI also reviewed B30 incentives, NFO commissions, and proposed performance-based TER, among other things, to improve the mutual fund industry.

B30, NFOs, performance

SEBI has proposed that if investors are switched from an existing scheme to a new fund offer (NFO), the commissions will be charged based on the original scheme. This measure ensures consistency and avoids potential disadvantages for investors during such switches.

Under the proposed rule, in cases where investors switch between Scheme A and Scheme B, where the commission payable for Scheme A is 1% and for Scheme B is 1.5%, the commission applicable to Scheme A will continue to apply even after the switch. This ensures that the commission structure remains consistent with the original scheme for the benefit of the investors.

SEBI has observed a practice where investor application amounts under the ₹2 lakh limit are split to take advantage of the B30 incentives. The B30 incentive is applicable only if the investment limit remains within ₹2 lacks.

The consultation paper highlights that investments made by B30 investors are sometimes churned through withdrawal and reinvestment after the minimum holding period of one year. This practice leads to additional expenses for the schemes for the same investment.

SEBI has proposed that charges should be based on actual flows rather than projections. This means that the charges imposed by mutual fund schemes would be determined based on the actual investment flows received, ensuring greater accuracy and transparency in calculating expenses.

SEBI has suggested that an additional commission, up to a maximum of ₹2000, may be fixed at 1% of the size of the first application or the amount committed through SIP by individual investors at an industry level. This proposal aims to regulate the commission structure and ensure a reasonable limit on the additional commission charged to investors.

SEBI has identified discrepancies in the costs of regular and direct plans, where investors bypass distributors and do not bear commissions. This discrepancy implies that regular plans may have higher costs due to including commissions, while direct plans have lower costs as commissions are not applicable.

SEBI has proposed the concept of performance-based TER and put forward two approaches. 

Under the proposed performance-based TER framework, the base expense ratio may be charged to investors during their investment period. At the time of redemption, management fees may be charged only if the generated return exceeds the indicative rate or the investor’s annualised return surpasses the hurdle rate. To discourage imprudent risk-taking, a maximum management fee may also be specified. The management fee can be deducted from the redemption NAV, and the remaining amount will be paid to the investor. This approach aims to align fees with performance and ensure fair compensation for fund managers.

Another proposed approach is to fix a higher expense limit for performance-based TER, where the TER, including management fees, is charged to the investor. In this approach, the TER charged by the schemes should be based on their performance in the previous year. At the time of redemption, if the AMC fails to generate a return above the indicative returns or if the investor’s annualised returns fall below the predetermined hurdle rate, the AMC may retain the applicable base TER and refund the remaining expenses charged to the investor, along with the redemption amount.

SEBI suggests that since this is a new concept, it can be initially tested in a regulatory sandbox. A regulatory sandbox provides a live environment for SEBI-regulated entities to experiment with new solutions and products.

Additionally, SEBI has proposed that any change in TER by an AMC should trigger an exit window for the investor, allowing them the option to exit the scheme if they are not comfortable with the revised expenses.

These proposals aim to introduce innovative approaches to performance-based TER, ensure transparency, and protect the interests of investors.

For any clarifications/feedback on the topic, please contact the writer at samiksha.swayambhu@clear.in