Sebi proposes overhaul of expenses charged to mutual fund investors

The market regulator has proposed that TER should be calculated at the AMC (asset management company) level, instead of the scheme level. According to the regulator, this would encourage more competition and help smaller AMCs, as well as help to pass on the benefit of the economies of scale to the investors.

Sebi also proposed the idea of performance-based TER and put forward two approaches (more on that later), but said the new concepts can first be tested in a regulatory sandbox structure.

The regulator also reviewed the AUM (assets under management) slab-wise structure, that determines the TER charges in the existing framework.

For the new framework, Sebi has proposed that at the AMC level, the maximum TER that can be charged for an equity scheme is 2.55%. This limit is available for AMCs that fall within the first AUM slab (upto ₹2,500 crore).

The maximum permissible TER rate has been increased slightly by Sebi from 2.25%, but it has been done to allow the mutual fund industry to adjust the TER for absorption of the GST (goods and services tax) borne on the investment and advisory fees.

All charges within TER

Sebi wants AMCs to charge all additional expenses within TER, to encourage uniformity and transparency.

On AMCs charging brokerage and transaction charges to the MF scheme as additional expenses, the regulator was of the view, “It has been observed that AMCs have executed trades through brokers who were not part of the top brokers (in terms of percentage share of the gross turnover of the stock exchange) and offered services at high brokerage costs compared to other empanelled brokers. If such a high transaction cost is for the research reports, the arrangement cannot be considered as a soft dollar arrangement and investors end up paying twice for the research i.e., one which is charged as part of investment management and advisory fees and another which is covered under brokerage and transaction cost.”

Sebi has even proposed that AMCs can be allowed limited membership of the stock exchanges to cover for their transaction costs, as the mutual fund industry has expressed that the TER-level limits may discourage fund managers from churning portfolios for the benefit of the scheme’s investors.

“Considering AMCs charge management and advisory fees for managing scheme assets, which should ideally include cost of research for selection of assets/securities for any scheme, it is hard to understand as to why significant expenses towards brokerage and transaction costs need to be separately incurred by fund houses and charged to investors in the name of research. Thus, charging brokerage and transaction costs which includes cost of research not only amounts to double charging the unitholders but also induce certain undesirable practices, impacting interest of unitholders,” the paper read.

Sebi also reviewed B30 (beyond the top-30 cities) incentives, commissions on new fund offers (NFOs) to avoid churning and proposed performance-based TER, among other things.

B30, NFOs, performance

Sebi has proposed that if investors are switched out of an existing scheme towards an NFO, the commissions will be charged as per the original scheme.

For example, if the switch is between scheme A and scheme B, where the commission payable for scheme A is 1% and scheme B is 1.5%, scheme A’s commission will stay applicable even after the switch.

According to Sebi, it has observed that to take advantage of the B30 incentives, there is a practice of splitting investor application amounts under ₹2 lakh-limit. The B30 incentive is only applicable if the investment limit is within ₹2 lakh.

“Investments of B-30 investors are often churned by way of withdrawal and re-investment after a year (one year is the minimum holding period requirement) which results in charging of additional expenses to schemes for the same investment,” the paper added.

These charges are also based on projections. Sebi has proposed that the charges are on actual flows and not on projections.

“Such additional commission may be fixed at 1% of the size of the 1st application or amount committed through SIP of the individual investor at an industry level, subject to a maximum of ₹2000,” Sebi added in its paper.

Sebi has also found that there is a discrepancy in the same costs charged to regular plans and direct plans (investors bypass distributors and don’t bear commissions).

Sebi also proposed performance-based TER. It proposed two approaches.

“During the period in which the investor remains invested, the base expense ratio may be charged to the investor. At the time of redemption, the management fees may be charged if return of more than indicative rate is generated or annualised return received by the investor is above the hurdle rate. The maximum management fees may also be specified to discourage fund managers from taking imprudent risk in order to earn higher fees. The NAV paid out at the time of redemption may be netted for the management fees and the balance amount may be paid to the investor.”

Sebi also proposed another approach.

“There can be another approach where higher expense limit for performance-based TER may be fixed and TER inclusive of management fees is charged to the investor. The TER charged by the schemes in such cases should be based on the schemes’ performance during the previous year. At the time of redemption by the investor, if AMC fails to generate return above the indicative returns for investor or the annualised returns for the investor is below the hurdle rate fixed in advance, the AMC may retain base TER as may be applicable and return the remaining expenses charged to the investor, along with the redemption amount.”

Sebi said as this is a new concept, it can be first tested in a regulatory sandbox. A regulatory sandbox is where entities regulated by Sebi can experiment with new solutions and products in a live environment.

Sebi also proposed any TER change by an AMC to trigger an exit window for the investor.