The Securities and Exchange Board of India (SEBI) has proposed tentatively that fund houses’ management fees be linked to them outperforming benchmark indices, throwing the Mutual Fund (MF) industry into a tizzy.
In an internal analysis, SEBI observed that just 26.67 percent of actively managed equity schemes had outperformed the benchmark index or gave similar returns over the five years ended February 28, 2023.
That has worried SEBI, which put forth the proposal that perhaps fund houses should earn a management fee only if they outperform the benchmark.
The performance-based fee model was proposed in a consultation paper put out by SEBI on March 18. It followed investor concerns over growing underperformance of MF schemes. Some investors have turned to passive schemes given their low cost, absence of fund manager risk and possibility of achieving near benchmark returns.
Can the proposal be implemented?
SEBI said the underperformance of MF schemes can some extent be attributed to a) sectoral, issuer level investment limits for MF schemes; b) scheme expenses (total expense ratio, or TER), c) transaction, liquidity, impact cost and d) cost of rebalancing of portfolio due to daily investment and redemptions in the scheme.
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“Any significant underperformance of the fund versus its benchmark is not in the interest of unitholders. Further, AMCs (Asset Management Companies) outperforming the market may find merit in charging unitholders with performance-linked TER, wherein the management fee is based on scheme performance. Thus, the concept of variable TER based on the performance of the schemes can be explored,” SEBI said in the consultation paper.
But can the proposal be implemented? Let’s dig a little deeper.
What is on offer?
SEBI has suggested that an AMC can charge a higher fee if an open-ended active scheme does better than an indicative return above the tracking difference adjusted benchmark (benchmark returns less operating costs of managing the MF scheme).
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Alternatively, the AMC can charge a higher fee if the scheme beats a pre-decided hurdle rate. The hurdle rate needs to be clearly defined in the scheme information document. In both cases, the management fee can be fixed or floating.
SEBI permits charging base expenses equal to those applicable to passive schemes if the AMC wants to go for performance-based fee for an actively managed equity fund. The regulator has suggested two ways of charging performance fee.
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First, the mutual fund will charge only base expense ratio on a daily basis till the time the investor remains invested. Maximum fees that can be charged should also be clearly defined so that the fund managers do not take imprudent risks to amplify outperformance. At the time of redemption, the fund house will compute the extent of outperformance (or underperformance). In case of outperformance, the fund will recover the management fees from your corpus and redeem your remaining corpus.
In the second approach, the fund house charges higher than base level expenses, which are based on previous year’s performance of the scheme. At the time of redemption, if the fund house has not managed to outperform the benchmark, then the fund house will return the expenses charged over and above the base expense ratio to the investor, along with the redemption amount.
Since this would be tried for the first time in the Indian MF industry on a mass scale, the regulator has made it optional to offer such a scheme and it has even put the model under the experimental regulatory sandbox arrangement.
Will it work?
The future of all good business ideas depends on the cost-efficient, flawless implementation in the real world, say experts.
“Mutual funds are pooled vehicles, where thousands of investors transact everyday. This arrangement can be tough to execute,” says a chief executive officer of a fund house on the condition of anonymity.
Deciding the extent of management fee based on performance at the time of redemption sounds like a good idea. But that can cause a lot of remorse and confusion.
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“How will investors react if they see the mutual fund house taking away some money, from the large chunk of money accumulated in the folio over the years at the time of redemption, citing outperformance?” asks another mutual fund official, who wishes not to be identified.
Weighing investor reactions
Think of a situation wherein an investor has accumulated a few lakh rupees for his retirement over a couple of decades in a scheme and at the time of redemption, the fund house credits a small amount to his account over and above his corpus stating they have underperformed.
The investor may keep thinking that he has been hanging out with an underperformer all these years, he adds.
Many distributors and fund officials expressed concerns around this ‘adjustment at the time of redemption’ as many thought that investors may think they are being cheated.
The CEO quoted earlier also said: “AMC needs money on an ongoing basis to cover its costs, pay distributors and also pay shareholders. How long should we wait for our share of money?”
The distribution community also expressed its own set of reservations about the performance-based fee.
“Performance of mutual funds needs to be assessed based on various factors including volatility, drawdowns and other factors on the ongoing basis and not just on the basis of returns on the day of redemption,” says a Registered Investment Advisor (RIA) who wishes not to be identified.
“Many investors do not understand the difference between growth and dividends even after investing in mutual funds for years. Many do not understand how the dividend amount payable to them is computed in mutual funds. We are yet to evolve to offer profit share arrangements to retail investors,” says a Mumbai-based mutual fund distributor.
That is not all. Fee-based financial advisors have found it difficult to convince their customers (investors) to write them a separate cheque as their fee.
Fund houses may, too, face this challenge, if their fees are separately shown and extracted from the investors’ corpus just when the investor is about to redeem.
SEBI has asked for feedback by June 1, 2023. It remains to be seen if SEBI goes ahead with this proposal and what shape it takes. We’ll keep you posted.