It is in this context that the Securities and Exchange Board of India (Sebi) had, in December, initiated a detailed study on the existing policies on TER and market practices of charging it to investors. Recent reports suggest that the regulator may propose the introduction of a uniform expense ratio across all fund schemes.
To be sure, as per the existing framework, there is a cap on the expense ratio on the basis of assets under management (AUM) of a scheme. In case of open-ended equity and debt schemes, the maximum TER that a fund house can charge is 2.25% and 2%, respectively on regular plans. As the AUM of the scheme goes up, the applicable TER has to come down. The idea is to pass on the benefits of economies of scale to investors.
If the proposed uniform TER comes into effect, all equity/debt mutual fund schemes would be subjected to the same expense ratio limit. This is aimed at discouraging the growing number of schemes in the mutual fund industry and to curb mis-selling of schemes. There have been reports that Sebi has taken note of some distributors nudging investors to redeem funds from existing schemes to invest in new fund offers (NFOs), which generally come at a higher expense ratio and thus attract higher commissions.
Further, reports also suggest that the regulator may bring GST (goods and services tax) and transaction charges—on buying and selling securities in the portfolio—in the ambit of TER. These are currently charged to an investor over and above the TER.
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Besides, AMCs could also charge an additional 30 basis points (0.3% of AUM) for retail applications of up to ₹2 lakh from B30 cities (locations beyond the top 30 geographical cities in India). This is to incentivize distributors for bringing in customers from the B30 cities. However, Sebi has temporarily barred fund houses from charging additional expenses for B30 retail assets, citing inconsistencies in implementing the B30 norms.
Sebi’s recent statement on this states that it has noticed mis-selling practices by distributors in B30 locations that includes splitting of transactions (to meet ₹2 lakh limit) and churning existing investments to reinvest for higher commission.
Here are some statistics pertaining to the growing number of schemes in the mutual fund industry year-on-year, top fund houses with large AUM charging higher expense ratio, and asset management companies (AMCs) paying higher commission to distributors on equity schemes.
Growing number of schemes
Mutual funds in India offer investors a plethora of schemes. As on date, there are about 1,284 schemes that include equity, debt, hybrid, and others, both active and passive funds that are open-ended. In 2022 alone, about 194 schemes were launched and these were dominated by passive schemes under both equity and debt. In around five years now, the number of mutual fund schemes grew by about 13% CAGR (compounded annual growth rate).
“If what reports suggest is true, by introducing a uniform expense ratio, Sebi wants to further rationalize the structure by considering the operational efficiencies that AMCs may have as they grow in size,” said Santosh Joseph, a mutual fund distributor based out of Bangalore.
“When the AUM size of an AMC goes up, the same team may continue to manage multiple schemes. When the fund manager, key management personnel, operations team and sales team across different schemes are all mostly same, why should there be a different expense ratio for an NFO? A uniform expense ratio across new and old schemes discourages unwanted proliferation of schemes,” said one of the persons associated with the mutual fund industry who did not want to be identified.
With a uniform expense ratio, distributors, too, will not have any incentive in coercing investors to invest in NFOs by redeeming their funds in existing schemes.
Not everybody, though, is in favour of the proposal. Some argue that a uniform TER may not bring in the desired results. “Instead, why not cap the commission paid to distributors on NFOs,” and “put a cap on the number of schemes that a fund house can launch,” are the opinions shared by some who are against the uniform expense ratio.
Higher expense ratio
Since Sebi’s rationalization of expense ratio structure in 2018—when the TER rates and slabs were altered—the yields of large AMCs have fallen. The yield of an AMC represents the fee collected from the investor as a percentage of the value of the investment. As their AUM grew, fund houses had to bring down the expense ratio to comply with the TER rules.
“AMCs were affected by a lower total expense ratio (TER), as mandated by the Sebi directive. Consequently, the yield on AUM for the top 10 players dipped from 69 basis points (bps) in FY18 to 48 bps in FY22,” according to a report on the mutual fund industry authored by Mohit Mangal from BoB Capital Markets. One basis point is one-hundredth of a percentage point.
Having said that, the revenue of the large AMCs has grown at a healthy rate in the last few years, with AUM of the industry now almost double that of 2018. Most large AMCs saw growth in PAT (profit after tax) yield due to reduction in costs likely on the back of economies of scale.
However, 15-50% of the equity schemes offered by the large AMCs with bulky AUM still charge a higher expense ratio of more than 2%. A majority of debt-oriented schemes charged much lesser TER than the maximum permissible limit.
Yet, any drastic changes can adversely impact the mutual fund industry, which is already highly regulated, opine those in the industry.
“Any rationalization of expense ratios in the equity side can be a retrograde step for the sector,” opined an industry veteran.
Bringing in GST and the transaction (brokerage) charges within the purview of TER is going to have a drastic impact on the profitability of the companies, as per those in the industry. “Any cap on the transaction charges will hinder the fund manager’s ability to transact,” added another industry representative.
Higher commission
In view of the higher number of NFOs launched in 2021 and 2022 amid a buoyant equity market, the commission paid by fund houses to the distributors went up in FY22, as per the BoB Caps report mentioned earlier. “At the industry level, the commission payout increased to 77 bps at the end of FY22 compared to 66 bps in the previous year,” stated the report.
There have been instances of smaller AMCs paying more than three-fourths of their fee collected from investors as distributor commission (see graphic) on their equity schemes. Such higher commissions may be a cause of concern for the regulator since it could lead to conflict of interest when fund houses pursue higher AUM.
Industry experts believe that a cap on the brokerage commission as a percentage of the TER could be a solution to this problem.
Conclusion
With mutual fund industry recording an impressive growth in AUM since 2018, it is perhaps time for Sebi to take a relook at the expense ratio structure of mutual funds.
The measures that the regulator may bring in can have a long-term impact on the returns that will be earned by mutual fund investors and improve the industry ecosystem.
Sebi’s move to lower the expense ratios in 2018 and ban upfront commission to distributors has had a positive impact on the industry in the last few years, as per experts.
Measures aimed at stopping newer schemes being launched just to push up the AUM and rules that enable the benefit of economies of scale for investors are essential now.