Huge reworking of fund expenses starts?

Yesterday, SEBI released a consultation paper on fund expenses with the long and descriptive title of Consultation Paper on Review of Total Expense Ratio charged by Asset Management Companies (AMCs) to unitholders of schemes of Mutual Funds to facilitate greater transparency and accrual of benefits of economies of scale to investors.

The document is a wordy 40 pages and covers every aspect of the expenses that investors end up paying to AMCs for investing in their mutual funds. The document shows that the regulator is starting a comprehensive overhaul of fund expenses.

Here's an overview of the areas covered, as well as brief excerpts highlighting the proposed change in that area.

TER limit should be inclusive of all expenses and charges
Currently, there are a few types of expenses that funds are allowed to charge over and above the total expense ratio limit imposed on them. These are:

• Brokerage/and commissions paid for transactions in the securities held
• Extra brokerage for the so-called B-30 cities
• An extra expense for exit loads
• GST on investment and advisory fees

The paper states that "The Total Expense Ratio, as the term suggests, should, in the interest of transparency, be inclusive of the total expenses charged to investors at any point of time. However, as presently certain additional expenses are permitted to be charged over and above the TER; thus there is ambiguity and lack of transparency in the manner in which unitholders are charged by different mutual funds. Thus, it is desirable that TER reflects the maximum expense ratio that an investor may have to pay and hence it should be inclusive of all the expenses permitted to be charged to an investor and the investor should not be charged any amount over and above the prescribed TER limits."

Essentially, SEBI recognises that the word 'Total' should really mean total. The paper then goes on to makes some observations and some recommendations for each of these areas:

Brokerage and transaction costs
Brokerage is specified as up to 0.12 per cent of trade value in case of cash market transactions and 0.05 per cent in derivatives. The largest AMCs expense on this head is Rs 524 crore and the smallest is Rs 3 lakh. As the paper notes, one small AMC actually reported zero brokerage expenses and Rs 3 lakh is actually the second smallest. It then says, "As the prescribed limits for cash and derivative transactions are chargeable for every transaction carried out by a scheme, the brokerage and transaction costs charged to the investors depend on the actual number and value of transactions undertaken by any scheme with no upper cap being applicable on total expenses towards such costs. As a result, there is no accountability of AMCs with respect to the total spending towards brokerage and transactions for any scheme. From the data shared by AMCs, it is observed that spending of some schemes towards brokerage and transaction cost is more than even the maximum TER limits prescribed. This has resulted in investors paying more than double the permissible TER limits prescribed for the scheme towards expenses."

This is scandalous, but SEBI says that AMCs claim that if this head is limited then trading that is in the interest of investors may have to be curtailed. It goes on to note that, "While on the face of it, there may be some merit in industry's arguments, it is felt that there is a greater need for accountability in the practices being followed for charging expenses from unitholders. 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 gross turnover of the stock exchange) and offered services at high brokerage costs compared to other empanelled brokers. If such high transaction cost is for the research reports, then the arrangement cannot be considered as 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's proposal: Instead of transaction wise limits, brokerage should be made part of TER. This will ensure visibility and impose a limit. This also includes the Securities Transaction Tax (STT). Additionally, AMCs may be allowed to become members of stock exchanges for the purpose of executing their own trades. This is already the case for debt holdings.

Additional expenses charged for promoting investments from smaller (B-30) cities
SEBI notes a number of anomalies which show that these additional commissions are being gamed to generate extra income and commissions. It proposes a number of changes in the system:

SEBI proposals:

• Extra commission payable only for new PANs at an industry level.
• Commission to be paid from the Investor Awareness and Education fund. Alternatively, the commission can be charged to the scheme, but in either case, if the investor quits within a year the sum must be credited back to where it was taken from (scheme or awareness fund).

There are some exceptions, like inherently short-duration schemes like overnight and liquid but essentially, the main thrust of the proposals is in ensuring that the money is paid for genuinely new investors.

Extra 0.05 per cent expense chargeable for exit load
SEBI notes many anomalies including the fact that total charges on schemes was 20 per cent higher than what was actually recovered from investors.

SEBI proposal: Complete abolishment of this expense head.

GST on investment and advisory fees
Currently, GST on all services except investment and advisory fees is charged to the investors and is part of the total TER limits specified by SEBI. However, GST on investment and advisory fees is permitted to be charged over and above the TER limit.

SEBI proposal: Bring all GST into TER but perhaps this would have a significant impact on the utilisation of the TER, and thus a suitable adjustment in the maximum TER needs to be made.

Review of slab wise TER structure
Currently, the smaller a fund, the higher the TER. SEBI's data analysis shows that this is being abused by AMCs. Investors are deliberately switched to smaller schemes and NFOs. Tellingly, such switching is much higher in regular funds than in direct funds. This suggests that distributors are doing this deliberately.

SEBI proposal: The TER slabs should be at the level of the AMC and not at the scheme level. For this purpose, equity and non-equity schemes will be bucketed separately.

Switch transactions and distributor commission
The paper presents a data analysis showing that distributors induce switching to take people to higher commission funds. This is, of course, widely known.

SEBI proposal: In case of a switch, the commission will be the lower of the two schemes. Additionally, The commission to distributor should be in increasing trend with the first year's commission not being more than 25 per cent committed to the distributor for first three years, OR the commission paid to distributor should be equal for all years.

Performance based TER
Conceptually, this is the biggest change that SEBI is proposing. However, at this point, the suggestions are simple. There are two alternatives that the regulator is asking for consultation on.

The paper states, "To start with, performance linked TER can be enabled for active open ended equity schemes wherein AMCs can charge higher management fees if the scheme performance is more than an indicative return above the tracking difference adjusted benchmark (Tracking difference adjusted benchmark means benchmark returns adjusted for permissible operational cost of managing the fund). Alternatively, AMC can be permitted to charge higher management fee based on a pre-decided hurdle rate as may be disclosed in the SIDs. Such higher management fees under both models can be either at a fixed rate or on returns sharing basis."

SEBI proposals:

• Approach A: 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 returns received by the investor is above the hurdle rate.
• Approach B: 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.

Obviously, the first approach is better from every view. However, there will surely be a long period of discussions on this issue.

This is an early, preliminary analysis and we will follow up with more details.

Meanwhile, we encourage readers to download the complete paper from https://bit.ly/sebi-ter, read it with care and respond with your comments to SEBI at the email addresses given at the end of the paper.