Performance-based fee for mutual funds: What stakeholders say

“At a time when discussions about reducing the expense ratio of schemes are going on, allowing higher expenses for performers is a welcome step. Investors won’t mind paying for schemes that deliver,” says a mutual fund CEO on the condition of anonymity.

Though details of this idea are not yet out, there are many voices in the industry that look at this proposal with a lot of caution. MFs charge a fixed percentage fee, ranging from near zero basis points to 225 basis points on the scheme.

For MFs, there are some fixed costs, such as fees payable to the registrar and transfer agents, and custodian fees in the money management business. Regular plans also account for distribution charges.

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The investment management fee (IMF) charged by asset management companies (AMCs) can vary within the overall limit of MF regulations. This IMF component is expected to be linked to the performance of the scheme.
“If the regulator wants to reward an AMC for outperformance, it should remove the cap on expense ratio,” says another CEO of an MF on condition of anonymity.

In case of variable expense ratio arrangements linked with performance, the base expense ratio of the scheme is typically lowered. For example, for a scheme that charges two percent for expenses under the fixed expense arrangement, the performance fee-based expense ratio should be kept at, say 1.5 percent. If the scheme is allowed to retain a certain part of the extra returns generated, over and above the benchmark, and the overall cap of 2.25 percent is enforced, it makes no sense as for a limited upside why would a fund house want to go for variable fee, the person asked.

Put simply, the mutual funds need sizeable reward for the effort they take after lowering fixed expense ratio, if they outperform the benchmarks.

Not the first time

Though the regulator is yet to start the long course on the proposal, like releasing consultation papers and taking stakeholder feedback, this is not the first such attempt in the MF industry.

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Sahara MF, which shut down operations in March 2020, had launched a scheme – Sahara Wealth Plus Fund - in September 2005. The scheme offered a variable pricing option in addition to traditional fixed pricing expense ratio option.

Under the variable pricing option, the scheme used to charge an expense ratio comprising a fixed charge to cover fixed expenses enlisted earlier and a variable IMF. The variable component used to depend on the performance of the scheme on a daily basis.

The maximum permissible IMF was charged for that day only when the portfolio returns were positive and exceeded the benchmark of the scheme. Half of the permissible IMF was charged in two scenarios – first when the portfolio returns were positive but have underperformed the benchmark on a day and second when the portfolio returns were negative but have outperformed the benchmark on a given day.

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The scheme charged no IMF, if the portfolio returns were negative and the fund manager underperformed the benchmark as well. Over a long period of time, though the variable pricing option did better than the fixed-pricing option, not many investors continued with their investments, as the performance of the fund house dwindled, along with that of promoter group.

Right benchmarking

Though the details of the new performance-based fee scheme are not yet out, many expect the regulator to allow the fund house to charge more if the scheme beats its benchmark.

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While the idea of charging extra expenses if and only if the scheme outperforms the benchmark is appealing, there are many conditions investors must keep in mind.

“Some MF schemes may have benchmarks far different from the schemes’ portfolio composition. In such cases, the quantum of outperformance may not be the true measure of the fund manager’s skill,” says Sandeep Bagla, CEO, Trust Mutual Fund.

Investors will also look at peer comparison and not just performance against benchmark. In a rising bull market, an equity scheme may offer five percentage points more returns than the benchmark and will become eligible for some performance-based incentive.  At the same time, there would be many others who may have beaten the benchmark by a far wider margin.

Also, if the fund manager does not make any money over the period of observation- say a year, but the benchmark and peers are down by 10-12 percentage points in the same period. As the scheme in question with zero returns has outperformed the broad market and peers in falling markets, will the investors be ready to pay incentives to AMC, he asks.

Most investors decide on their investments by looking at short-term performance.

Operational hiccups

While performance-linked fees or profit-share arrangements are prevalent in portfolio management service (PMS), implementing the same in open-ended MF schemes where thousands of retail investors transact daily is difficult.

In a PMS, typically, investors opting for profit-share arrangements pay an agreed percentage of profits above a threshold return, periodically.

Quantifying outperformance to the benchmark and charging performance incentives from each MF investor can be a daunting task as many of them keep entering and exiting open-ended schemes whereas some could be very long- term investors.

“Accounting for outperformance in expense ratio, which is charged on the daily net assets of the scheme at a time when active fund managers aim to outperform in the long term, may not appeal to many investors,” says another mutual fund CEO who wish not to be quoted.

Impact on investors

Though investors may see this as another step in the direction to make MFs more accountable, advisors, however, are in a wait-and-watch mode. According to a SPIVA (S&P Indices Versus Active Funds) India report, over the five years that ended in December 31, 2022, 93.75 percent large-cap equity schemes have underperformed the S&P BSE 100, a large-cap index.

The first reaction of many investors would be that if funds want to charge more, they must work harder to outperform.

“Though, initially, performance-based fee may make fund managers work harder to earn their fees, there is also a risk that some fund managers may want to take a bigger risk in a quest for higher rewards,” says Nirav Karkera, Head of Research, Fisdom, a mutual fund distribution platform. We need to wait and watch how this arrangement is defined and how it evolves over a period of time, he adds.

The modalities of this idea are yet to be announced and savvy investors and advisors are expected to change their stance accordingly.