The Securities and Exchange Board of India, or SEBI for short, is India’s securities and commodities markets regulator, and it has recommended a significant alteration to the cost ratio charged by mutual funds. The regulator recently released a consultation document seeking to simplify and tighten the definition of the total expense ratio (TER) by including all peripheral expenditures that fund houses were permitted to levy in addition to the TER.
An investor should be aware of these 5 major changes recommended by SEBI.Â
Commissions paid to brokers are part of the TER
The maximum TER that an equity fund may charge its investors is 2% (for the first 250 crores). As a result, the rate drops to 1.75 percent for the first Rs 1,250 crore, 1.60 percent for the subsequent Rs 1,500-3000 crore, and so on. However, the fund is free to impose additional charges for things like administrative costs.
Fund houses may already collect brokerage and transaction fees totaling up to 0.12% of the trading amount. SEBi discovered that fund firms were collecting brokerage fees above those allowed by TER. The investors had no idea they were covering that cost.
According to SEBI’s research, fund firms include the cost of brokerage reports in the fees they charge their customers. According to SEBI, this practice is deceptive since it keeps investors in the dark while also requiring them to pay twice as much for research (first in the form of management fees to the fund manager and again in the form of increased brokerage costs).
Dip into the investor education fund
One percent of a mutual fund’s daily net assets is put aside each year for an investor education fund. SEBI hopes that this funding will be put to good use. The market regulator has proposed that the investor education fund be charged by the fund firms that previously charged the investor.Â
It was also requested that money formerly allocated to distributors for bringing in customers outside of the top 330 twins (known as the B30 towns in MF lingo) be reallocated to the investor education fund.
SEBI also found that investors in B30 cities often withdraw their funds within a year. It indicated that the higher fee to distributors may remain beyond the first year for inflows from B30 towns, contradicting market rumors from a few months ago that SEBI could eliminate the B30n incentives.
The market regulator also suggested that fund firms provide incentives to distributors to attract more female investors. The fee for this service may come from the investor knowledge pool as well.
There’s No Outcome Blow
The market regulator observed that between April 2021 and September 2022, 29% of the inflows into NFOs originated from existing schemes of the different fund houses. NFO stands for “new fund offer” and refers to a newly-launched scheme. Oddly, 93% of this originated from established designs. Investors that deal directly with the fund house or their RIA are eligible for direct plans.
Distributors peddle the more commonplace plans. Furthermore, it found that roughly 72% of mutual fund investments were cashed out within the first two years. Distributors who move your money from one plan to another would be paid the lowest of the two schemes’ commissions, as suggested by SEBI.
Compensation based on results
The subject of whether or not your fund management should profit from your losses as an investor is a common one. Only 40% of the schemes (regular plans) have beaten their benchmark indices over the last year, according to the report by SEBI. Only 27% of programs have outperformed the benchmark indexes during the last five years.
The performance-linked TER that SEBI has suggested is a significant departure from current practice. The proposed change is intended to take effect at the investor level. Simply stated, you will be charged management costs (fund manager fees) when you cash out of your fund. When you seek redemption, the fund house swiftly determines whether you are departing as a satisfied client or not based on the growth or loss of your investment.
Your return on investment will be reduced by the amount the fund house charges for its management, even if the fund itself achieves positive returns. SEBI also suggests that the fund company may assess a TER for the duration of your investment. The fund house will determine whether it has earned more than the stated return after processing your request to redeem. The management costs will be refunded if this is the case.
Redesigning the TER
When it comes to how fund firms account for costs, SEBI has recommended a radical change. As it stands, a scheme’s ability to demand large fees is proportional to its corpus size. As the fund size increases, costs decrease.
However, SEBI conducted an extensive investigation and determined that the formula had significant flaws. While fund companies do pass down the cost savings from economies of scale to debt funds, individual investors do not share in such savings.
Sebi has recently suggested breaking down costs by kind. The cost structure for equity funds will be uniform, whereas the TER structure for debt schemes would vary. The pricing of a hybrid scheme’s equity assets is determined by the equity structure, while the pricing of its debt assets is determined by the debt structure.
