After coaxing, cajoling and counselling the Indian mutual fund industry to bring down its costs to investors, the Securities Exchange Board of India (SEBI) finally took matters into its own hands this week. In an action-packed Board meeting, it revisited the cost and commission structure for mutual funds by announcing a new slab structure for scheme expenses, banning upfront commissions, asking AMCs to be more transparent on costs and tweaking the B30 allowance for assets sourced from smaller cities.

While these changes are certainly great for existing fund investors, they may turn out to be a mixed blessing for the growth and development of the fund industry.

Cost cuts for investors

With the ban on entry loads in 2009, SEBI ensured that all the fees and costs chargeable to the investor are packed into a single Total Expense Ratio (TER) expressed as a percentage of a scheme’s net assets. The exit load is the only additional levy, allowed in cases of early exit.

However, the slab-based structure had not been revised from the time SEBI introduced its mutual fund regulations in 1996. TERs for equity and hybrid schemes start out at 2.5 per cent of daily average net assets for the first ₹100 crore and fall to 1.75 per cent for all assets beyond ₹700 crore. The caps are 25 basis points lower for debt funds.

But with MF assets growing by leaps and bounds, these slabs had become quite obsolete. A listing from Value Research shows that, as of end-August 2018, there were as many as 45 pure equity schemes that topped ₹5,000 crore in assets, 18 schemes that managed ₹10,000 crore and six wildly popular schemes that managed assets of over ₹20,000 crore.

To allow all schemes ranging from a ₹700-crore midget to a ₹22,000-crore giant to levy the same TER is quite unjust to investors. After all, managing portfolios is a highly scalable activity and steering a ₹22,000-crore portfolio certainly doesn’t require 31 times the effort that a ₹700-crore portfolio does.

SEBI’s latest circular therefore forces calibrated reductions in expenses, as funds scale up beyond ₹700 crore. Under the new slabs, open-end equity schemes can charge a maximum of 2.25 per cent for the first ₹500 crore of assets, 2 per cent for the next ₹250 crore and 1.75 per cent for the next ₹1,250 crore. TERs drop to 1.60 per cent and head lower as assets scale up beyond ₹2,000 crore.

A ballpark calculation shows that investors in equity funds with AUMs higher than ₹2,200 crore stand to make savings in TERs of 30 to 60 basis points under the new slabs. This can compound to quite a sizeable sum for the investor in the long run. A desirable side-effect of this move would also be to curtail the disproportionate financial clout that the top AMCs enjoy over distributors and competitors.

Close-end clampdown

SEBI has also adroitly used the TER review to clamp down on the flurry of close-end scheme launches, which the industry has taken to lately. From the investor standpoint, close-end funds suffer from several disadvantages vis-a-vis their open-end cousins. They lock in investors irrespective of performance, operate to vaguely defined and duplicated mandates and often charge investors at the highest TER slab. By capping the maximum TER for close-ended equity funds at 1.25 per cent (1 per cent for debt), SEBI has now provided strong disincentives for MFs to prefer close-end funds.

Move to all-trail

The third big pro-investor measure is the move to bar upfront commissions and force MFs to move to an all-trail model for their distributor commissions.

Though upfront commissions paid out of the scheme have been forbidden for many years, many AMCs do pay upfront commissions to intermediaries out of their own pocket to push products.

A move to an all-trail model can completely align the investor’s interest with that of his advisor or distributor and discourage unnecessary churn.

In an all-trail model, an advisor earns his fee as an annual percentage of his clients’ assets. Thus, if the investor sells funds or his NAV slumps due to poor performance, the distributor takes a haircut on his earnings too.

Negatives for the industry

But while SEBI’s latest moves are certainly pro-investor, there are three aspects to them that have the potential to extract a heavy price from MF intermediaries and by extension, the MF industry.

First, there’s a question of whether SEBI’s relentless pressure on the mutual fund industry to trim its costs and distributor incentives will open up an even wider regulatory arbitrage with other financial products.

While SEBI has been keen to hold MFs to ultra-high standards on costs and transparency, regulators of competing financial products (such as IRDA) seem to be under no similar compunction.

In regular premium traditional insurance policies, first year commissions of 35 per cent plus to agents are still commonplace. Even under SEBI’s ambit, Portfolio Management Schemes and Alternative Investment Funds levy high fees consisting of both a fixed fee (usually 2 per cent) and a performance fee (15 to 20 per cent on profits over a hurdle rate). Widening fee differentials between MFs and other products may nudge both AMCs and talented fund managers to abandon the MF vehicle for greener pastures.

Two, there’s the issue of whether the TER haircuts passed on by AMCs can squeeze the already poor takings of the small financial advisor who services the retail investor. With both the regulator and AMCs on a cost-cutting drive, the number of active individual distributors in the MF industry has been dwindling in recent years.

Wealth Forum E-Zine has presented calculations to show that over 58,600 of the 69,000 Independent Financial Advisors (IFAs) distributing MFs probably make a pre-tax monthly income of less than ₹22,000. Given that Indian investors have shown marked reluctance to move to a fee-based advisory model, declining revenues can turn the business models of many IFAs unviable.

This may have direct implications for MF penetration and the quality of MF advice and services received by small investors.

Finally, while SEBI is right to discourage upfront commissions, one wonders whether it has gone too far in forbidding AMCs from using their own P&Ls to pay any kind of incentives to their intermediaries. One is hard-pressed to think of any consumer-oriented industry that has scaled up to a reasonable size without using its profits to engage and reward its distribution partners.

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