The year started with a disadvantage for equity funds as the Budget reintroduced LTCG tax on gains exceeding 1 lakh, but Sebi's moves to cut costs and bring in more transparency make mutual funds a cheaper and simpler product for investors. On the other hand, defaults in high-rated debt securities jolted debt fund investors as returns fell and liquidity became an issue
The year 2018 will be remembered as the one in which investors saw their returns from mutual funds being affected by factors other than their own performance, especially in the equity space. The budget reintroduced a 10% long-term capital gains tax on gains exceeding ₹ 1 lakh on equity-oriented funds and imposed a 10% (plus surcharge and cess) dividend distribution tax on dividends from these funds, thereby reducing the effective return. But then, through the year, capital market regulator Securities and Exchange Board of India (Sebi) stepped in with measures—to streamline expenses, increase transparency and iron out regulations where there was some ambiguity—that are expected to reduce costs thus enhancing returns in the long run.
In September 2018, the regulatory limits on expenses that a mutual fund can charge were lowered and linked to the assets under management (AUMs) in an effort to pass on the benefits of scale to investors. Sebi defined AUM ranges and the expense ratios applicable to each for equity-oriented and other-than-equity-oriented schemes. For example, open-ended funds with AUMs of ₹ 2,000-5,000 crore and ₹ 5,000-10,000 crore can now charge up to 1.6% and 1.5% for equity-oriented schemes, respectively, and 1.35% and 1.25% for other schemes, respectively. The limits are lower for closed-end funds—1.25% for equity-oriented funds and 1% for other funds.
Earlier, in April, Sebi redefined the eligibility to charge additional total expense ratio (TER) for inflows from beyond top cities. It said additional expense of up to 30 basis points can be charged if net inflows from individual investors from beyond top 30 cities constitute either 30% of gross new inflows or 15% of the average AUM (year-to-date), whichever is higher. Earlier, this was allowed for all inflows from beyond top 15 cities.
Another loophole Sebi plugged was reducing the expense allowed in lieu of credit back of exit loads to schemes from 0.20% to 0.05%. Only open-ended funds would now be able to charge this. These measures led to a meaningful reduction in TER to the advantage of investors. These moves have capped the expenses charged each year to a mutual fund scheme.
Sebi also came out with regulations to make expenses more transparent. All expenses, including commissions, now have to be paid only from the scheme and not from the AMC or sponsor or another entity. Earlier, the base TER was declared without distinguishing the components. Now fund houses have to provide the breakup of total expenses as management expenses and others in the half-yearly consolidated account statement or CAS. This eliminated the possibility of fungibility between expense heads.
Sebi also directed that under no head can the expense of the direct plan be higher than that of regular plans.
Distributors feel the pain: Tightening of expenses directly affected commissions as most funds passed on the reduction to distributors. “Smaller AMCs which rely more on individual IFAs (independent financial advisors) are likely to take the reductions on their own books. But larger AMCs and listed AMCs that have a P/L to manage are likely to pass on the reduction in allowed expenses in the form of lower commissions," said Jiju Vidyadharan, senior director funds and fixed income research at Crisil.
Sebi also barred AMCs from bearing distributor commissions and incentives in any form; these have to come from schemes within prescribed limits. Dhruv Mehta, chairman of the Foundation of Independent Financial Advisors (FIFA), talks of a sense of gloom among IFAs in towns like Jalandhar, Guwahati, Valsad and Surat. “Instead of being patted on the back for building the SIP book to where it is they are being penalised with lower commissions," he said.
To prevent mis-selling and churning investors’ money, upfront commissions were banned and the industry was directed to follow a full trail commission model. While this is likely to improve the quality of flows into mutual funds, it may affect penetration in smaller towns. “Many new IFAs entered B30 cities because of the upfront commissions and helped build the business. This may stall now," said Mehta. “Existing IFAs are committed because they feel there is a need for the product in their investors’ portfolio." He added that as incentives for distributors in mutual funds come down, they may be forced to add other products with better commission structures.
Sebi’s reclassification of schemes also had an impact on investors. “The sharpness and clarity in the product definitions now will make it easier for investors to complete their investment basket," said Radhika Gupta, CEO, Edelweiss Mutual Fund.
“Where schemes were merged or the character of the scheme changed significantly, we have asked investors to adopt a wait-and-watch approach," said Shilpa Wagh, founder and financial life coach, Wagh Financials. While she liked the decluttering that the move enabled, the recommendation to her investors was to suspend SIPs and wait for clarity on how the scheme’s revised mandate affected the risk and returns and understand the tax implications better. “The move addressed the challenges linked to products being true to label," said Vidyadharan. “There is still some scope for fine tuning especially on the debt side. There can be significant divergence in the credit quality of funds in a duration band because there is no credit control," said Vidyadharan.
The year 2018 also saw the rise of the individual investor and equity as the dominant asset class in mutual funds. Data from the Association of Mutual Funds in India (Amfi) shows that the share of the individual investor in industry assets which was 48.8% in November 2017 rose steadily through 2018 to 54% in November 2018, while the share of institutional investors declined from 51.2% to 46% in the same period. The share of equity-oriented schemes in the industry’s assets rose from 38.4% in November 2017 to 42.1% in November 2018. In the same period, the share of debt-oriented schemes (excluding liquid schemes) fell from 39% to 29.6%.
The industry will realign to new norms in 2019. The reality of the mutual funds becoming more pro-investor provides opportunities for businesses to be built.