In probably a first-of-its-kind case, capital market regulator Securities and Exchange Board of India (SEBI) imposed penalties on DSP Investment Managers (the asset management company of DSP Mutual Fund) and its Trustee company (DSP Trustee Co) for absorbing expense ratios of one of its schemes.
The case pertains to DSP Nifty 50 Exchange Trade Fund (ETF), where the expense ratio was 0.16 percent. However, since DSP Nifty 50 ETF (DN50) was launched in December 2021, the fund house charged just 0.07 percent to the scheme as its expense ratio. DSP Investment Managers absorbed the balance (0.09 percent) on its own books. In other words, it showed only 0.07 percent as the scheme’s official expense ratio.
SEBI objected to this saying it violates a circular that the regulator had issued in October 2018. The circular had made it mandatory for fund houses to charge all scheme-related expenses to the schemes only. The circular had said that expenses must not be paid by the asset management companies’ (AMC) books or those of its associates, sponsors, trustees, or any other firm.
SEBI has imposed a penalty of Rs 1 lakh each to the fund house and the trustee company.
What really happened
Launched in December 2021, DN50 collected Rs 11.81 crore. By the end of that year, its corpus has inched up to Rs 11.89 crore and by March 2022, its corpus was Rs 22.59 crore.
In its defence, the fund house said that the costs of running an MF scheme, even a passive scheme like an ETF, can push the total costs up and that might make the scheme (DN50, in this case) unattractive when compared to its peers. “Therefore, the operating cost of the scheme as % of AUM (assets under management), if all expenses are to be borne by the schemes, will be high initially when the scheme is scaling up its AUM,” wrote the fund house to SEBI in June 2022, as part of its defence.
It argued that if the scheme were to bear the entire operating expenses (0.16 percent), it would be “an outlier”.
To be sure, SEBI allows passive funds like ETFs and index funds a maximum total expense ratio (TER) of one percent. In reality- and to stay competitive- many passive funds charge far lower than this. The average expense ratio charged by large-cap ETFs (the category to which DN50 belongs to) is 0.08 percent, as per ACE MF. Of the 33 large-cap ETFs out there, data for 31 such ETFs is available. Thirteen of these ETFs charge expense ratios of up to 0.07 percent; what DSP Investment Managers charged DN50.
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Index funds charge a bit higher; the average expense ratio charged by them is about 0.29 percent, as per ACE MF.
The fund house argued that in order to scale up, it needed to keep its costs low (albeit, by artificially charging the scheme a lower expense ratio) to make it attractive to investors. “If TER is increased, it will further discourage investors to invest in this scheme and thus restrict its capability to increase the AUM. With increase in the AAUM (average assets under management), the operating expenses as % of AAUM will gradually reduce and the total scheme expenses will be below the TER charged,” wrote the AMC to SEBI.
SEBI didn’t buy the fund house’s argument. Here’s why.
In 2018, SEBI had issued a circular mandating that fund houses must charge all MF scheme-related expenses to the schemes only. It prohibited AMCs to absorb charges; a practice that was rampant in the Rs 40 trillion Indian MF industry for years. It was common industry practice to tempt distributors by taking them out on foreign trips. The 2018 circular put a stop to that when it restricted the ability of fund houses to spend. By limiting all expenses to a scheme’s TER, it ensured that fund houses keep their costs in check.
DSP argued that ETFs do not pay any distributor commission since ETF units are bought and sold on the stock exchange. And the intent behind absorbing a portion of the scheme’s costs was not to mis-sell. Therefore, it added, it did not violate SEBI’s 2018 circular. The fund said that SEBI’s 2018 circular that prohibited AMCs to absorb expenses on their own books was to prevent mis-selling.
But DSP Investment Manager’s biggest defence was this: the total expenses it incurred on DN50 (the costs that the AMC absorbed plus what it charged to the scheme; 0.16 percent) was far less than the upper limit of one percent that SEBI has mandated for passive funds. According to its interpretation of SEBI laws, since the total costs of DN50 (0.16 percent) were well within SEBI’s upper limit (1 percent), the fund house has done nothing wrong by absorbing a part of the expenses, especially given that there was no intent to pay any extra commission to the distributor and induce mis-selling, as feared by SEBI’s 2018 circular.
In 2019, SEBI did allow AMCs to take some bit of expenses on their books; this was limited to two basis points of the schemes’ assets, only if the scheme’s costs exceed the upper limit of expenses (one percent in an ETF’s case). A basis point is one-hundredth of a percent point.
Here too, the fund house pointed out that SEBI doesn’t prohibit fund houses from absorbing a portion of a scheme’s expense. SEBI said that the portion absorbed by the fund house (0.09 percent) was still far greater than the absorption limit (0.02 percent) that SEBI eventually allowed in 2019.
Further, SEBI also pointed out in its order that DN50’s offer document didn’t mention the fund house’s intent of absorbing the 0.09 percent of its costs, even though it had explicitly mentioned that it would absorb the scheme’s new fund offer-related expenses and what comprises this NFO expense.
Transparency or admission?
The fund house also claimed, in its defence that it voluntarily disclosed this information to SEBI as part of its quarterly test report that all AMCs must submit to SEBI and also as part its half-yearly trustee report, both for periods ending March 2022. That is what alerted SEBI to what really happened at the fund house and DN50, in particular.
SEBI argued that these reports are specifically meant for fund houses and trustees to report any divergence from SEBI rules. That the fund house and trustees mentioned the excess TER absorption as part of these reports, itself shows that they knew of the ramifications.
In its order, SEBI reiterated that it is wrong of AMCs to absorb expenses on their books. This, added SEBI in its order, could put large fund houses with deep pockets at an unfair advantage as compared to smaller AMCs.
The penalty imposed by SEBI on DSP Investment Managers might look tiny as compared to what it usually imposes. But the order assumes significance given the regulator’s recent announcement that it has begun an examination of fees and expenses that mutual funds charge. On the one side is the defence by DSP Investment Managers that costs need to be competitive to attract investors; a line that arguably many other fund houses would also echo. On the other hand, SEBI’s intent to re-look at mutual fund costs may just as well appear that it might feel costs are high, especially given that it had cut costs as recently as in September 2018.
(Dhuraivel Gunasekaran contributed to this story)