BackIs there a financial incentive in keeping equity funds small?
Data shows that the largest number of equity funds is in the category with the lowest assets under management
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Mumbai: A graded fee structure that allows mutual funds to charge higher fees for smaller schemes may be leading to smaller size of new fund launches, data shows.
A look at data from fund-tracker Value Research shows that the largest number of equity funds is in the category with the lowest assets under management (AUM). Funds with AUM of less than ₹ 100 crore account for 164 out of 451 equity schemes that are currently offered by Indian mutual funds. They have a median expense ratio of 2.86%. That is followed by 139 funds that manage assets between ₹ 100 crore and ₹ 400 crore which have a slightly lower expense ratio.
The Securities and Exchange Board of India (Sebi) allowed a graded fee structure so that smaller schemes—which are allowed to charge larger amounts—can meet their expenses better. There are also additional charges allowed for reaching out to areas beyond the top 15 cities.
But that may be acting as an incentive to launch smaller schemes. Multiple smaller schemes—often with the same characteristics and investment goals as existing larger schemes—can charge higher fees from every incremental rupee in inflows (see chart below).
The only exception to the trend is the largest segment, which has 109 schemes. But then, this category also has the oldest set of schemes which means it would have had the longest time to grow, and cover a larger period of fund launches. It has a median age of 10.51 years compared with 5.63 years for the sub- ₹ 100 crore category.
Manoj Nagpal, chief executive officer, Outlook Asia Capital, a consulting and wealth management firm said that it makes sense for fund houses to launch multiple closed-ended schemes under the current system.
“An NFO (new fund offer) results in higher earnings for the fund, and also allowed them to pay out higher commissions to distributors," he said.
This has resulted in fund houses often launching multiple closed-ended schemes with the same mandate. A closed-ended fund also ensures that investors remain locked in for a sufficiently long period of time for the equity investment to bear fruit, but each individual scheme would have a high expense ratio because of the small size of the fund.
Dhirendra Kumar, chief executive officer of fund tracker Value Research, pointed out that there were a lot of closed-ended schemes launched which were used to pay higher commission to distributors.
The question of distributor compensation has been a talking point for the mutual fund industry for some time now. The regulator Sebi and industry body Association of Mutual Funds in India have tried to bring down upfront commissions in a bid to avoid mis-selling by distributors. Fund houses earlier charged investors 6% in NFO expenses, which was amortized over a five-year period. Sebi regulations disallowed this in 2006. It later barred entry loads in 2009.
Investment adviser Jayant Vidwans, former president, Society of Financial Planners, agreed that the amount a distributor makes has declined over the years, and new fund offers were larger in earlier years than they are now. He said that if funds charge higher fees on smaller funds (though within Sebi limits) they would be better able to compensate distributors. This is because there would be a better ratio between what they are getting from investors, and what they pay out to distributors.
“But this is not a sustainable practice. The scheme performance could be affected by the higher fees," he said.
“That is not true of the bulk of the well-positioned large funds... I don’t think it is fair to say that overall we are out of line," said an executive working with a mutual fund who didn’t wish to be named.
A Mint report has suggested that Sebi is looking to bring down the expense ratios overall. This will mean a smaller differential between the highest and the lowest equity MF expense slab, reducing the incentive for smaller schemes.
To be sure, the only reason that the money actually came into mutual funds in the first place could be because of the unique nature of the product that had been launched, small though it may be. Examples of this could be the funds with a mandate to invest abroad. But there are also many examples of multiple series of the same kind of fund, for example, multiple closed-ended mid-cap schemes with the same mandate.
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