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Opinion | SEBI is to blame for high mutual fund expense ratios

While SEBI’s intention of driving industry growth is honourable, sacrificing investor returns by increasing costs is questionable

August 27, 2018 / 10:07 AM IST

Manoj Nagpal

Last week, the chairman of the Securities and Exchange Board of India (SEBI) Ajay Tyagi said there was a need to cut the high expense ratio charged by mutual funds. But a look at the history of the current expense structure shows that the regulator itself is to blame for higher costs charged to mutual fund investors.

Indian mutual funds have a composite expense structure known as the total expense ratio (TER). With no entry loads or any other holding costs, the net asset value (NAV) of mutual funds accurately reflects net investor returns. This is unlike other countries that follow different models.

For example, in the United States, there is a dis-aggregated cost structure and the custody costs, advisory costs, platform costs, etc., are not built into the NAV. Hence, the NAV only reflects the return that the fund manager generates and is not indicative of an investor’s net return. Thus the comparison of global expense ratios with India needs to be done taking care of these factors. The Indian cost structure has the advantages of simplicity, but it also has the built-in disadvantage of conflict of interest that a charlatan distributor or adviser can misuse.

Till 2012, Indian mutual funds had a well-regulated stepped cost structure. The maximum an equity mutual fund could charge was 2.5 percent, including service tax. As assets under management (AUM) increased, costs came down. An average equity mutual fund used to charge around 1.75 to 2.25 percent. Remember, fund sizes were smaller then and even then the TER was lower.

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In 2012, SEBI decided to change this in order to improve growth and increase penetration. To be fair, the industry AUM then was around Rs 600,000 crore and growth was insipid. SEBI decided that investors should bear these extra costs to drive growth. The regulator made four significant changes that increased mutual fund costs.

One, it allowed service tax (now GST) on investment management fee to be charged as an additional charge. Two, it made the TER fungible. Three, it allowed mutual funds an additional charge of 20 basis points (of AUM) in lieu of an exit load. Four, it allowed expenses of 30 basis points for mutual fund penetration beyond the big cities.

The net effect of these changes was a significant increase in costs for investors. Total costs increased by 75 to 85 basis points. Now, an equity mutual fund could charge around a maximum of 3.3 percent compared to 2.5 percent earlier. Obviously, all mutual funds increased the investor costs to match these new higher limits.

While SEBI’s intention of driving industry growth is honourable, sacrificing investor returns by increasing costs is questionable. Each change that SEBI implemented was flawed.

In allowing service tax to be charged above the TER only for investment management fees and not for others like custody charges, R&T fees, distribution fees, etc., SEBI made an arbitrary cost increase that favoured asset management companies (AMCs). This was selective application of tax laws at best and an underhand way to favour the AMCs at worst.

Making the TER fungible led to arbitrary increases in investment management fees. Earlier, mutual funds could charge only 1.25 percent for assets up to Rs 100 crore and 1 percent beyond within the overall TER. This was in line with global standards. Economies of scale in other areas would translate into a lower overall TER.

Earlier, mutual funds had to show actual expenses beyond the 1 percent investment management fees to claim additional expenses. As a scheme grew, actual expenses did not increase proportionately. Hence, it was getting difficult for mutual funds to claim these expenses and some mutual funds had to charge lower than the allowable TER. Fungibility of the TER took away this difficulty for mutual funds and now they could charge the entire allowable TER, even if there were no additional expenses.

Third, allowing 20 basis points as compensation in lieu of exit loads was a double whammy for investors. Globally exit loads are used to compensate existing investors for short-term exits by other investors and not the AMC. But the 20 bps compensation to the AMCs was 5-7 times more than the exit loads credited back to existing investors. Initially, SEBI allowed it for all schemes even if those schemes did not charge an exit load. But finally, realising its folly, SEBI disallowed it and has cut this to 5 bps.

Similarly, allowing additional charge of 30 bps from all investors to promote growth in smaller cities was a misstep. If a company wants to grow, its shareholders have to provide the growth capital. Especially now when top AMCs are making significant profits.

For example, HDFC AMC made a profit after tax of Rs 722 crore for FY 2018. Why should the regulator allow it to charge additional expenses to investors to grow its business? There is no rationale for existing MF investors to fund the shareholder’s future profits. Why can’t expansion be funded from profits?

In the ultimate analysis, total costs for investors should move down as the scale and size of the AUM increases. Total costs is the sum of fund management costs, distribution/advisory cost and operational costs. SEBI (and the industry) should think through what components of the total costs need to, and can, come down.

Active equity fund management costs globally are in the range of 0.5-0.75 percent compared to 1-1.5 percent for India. Distribution/advisory costs globally are at an average of 1 percent, in India this is at an average of 0.76 percent.

For overall costs to move down, India either needs to shift to passive index investing or cut down on active fund management costs in line with global averages. That’s not to say other costs cannot come down. With technology and growing scale, even the distribution and operational costs will move down. The mutual fund industry has to keep investor interest first rather than chasing growth at the cost of the investor.

(The author is a consulting editor with Moneycontrol. He tweets at @NagpalManoj)
Manoj Nagpal
first published: Aug 27, 2018 09:59 am

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