Opinion | Mutual funds will now be cheaper and less cheatable

The capital market regulator, the Securities and Exchange Board of India (Sebi), has once more moved in investor interest in the mutual fund industry. The mutual fund you buy will soon cost less, be less prone to mis-selling and be more transparent. These are the four changes that will make an already investor friendly product go several steps ahead.

One, Sebi has lowered the costs in a mutual fund. An expense ratio in a mutual fund is the cost that the investor pays. The regulator fixes the maximum a fund can charge and leaves it to competition to drive costs down. Levied on the assets under management (AUM), these costs were fixed in 1996 when the industry size was around ₹ 30,000 crore. Costs in a mutual fund were expected to come down as the size grew because fixed costs do not grow with the size of the AUM. The benefits of larger size, it was assumed, would be passed on to the investor. The industry size is now ₹ 25 trillion but the costs in the retail part of the market have stayed near the maximum limits; in the institutional part (liquid funds and debt funds), costs have been slashed due to the higher bargaining power of the big customers. Retail customers have no organised voice and continued paying more even as the size of the industry indicated a cost cut. Sebi has now cut the maximum a fund can charge and costs over the board will come down.

But why is the market regulator fixing prices? Isn’t that the job of the market to work through? Markets work but sometimes there is market failure and then a good regulator will step in. The market failure in the case of costs in the mutual fund industry has been the failure of some of the large fund houses to pass on the benefits of scale to investors. When a market begins to display characteristics of an oligopoly where a few large firms begin to fix prices and collude, the regulator has to step in. This is what Sebi has done. The regulator has data to show that this is happening and I would hope that this data is made public soon. The cost decision has been taken after a rigorous research and data exercise by the excellent mutual fund team in Sebi. Good decisions are based on good data analytics and not whims. The cost decision is based on very firm data and its analysis. 

Two, no commissions will be upfronted anymore from any source for all parts of the industry other than the systematic investment plan (SIP). When C.B. Bhave removed the front load in 2009 in mutual funds, the industry immediately began upfronting trail commissions. Now almost a decade later, upfronting has become the new reason to churn investors. Mutual funds are using a mix of closed- end funds, own capital and higher expense ratios to upfront higher and higher amounts leading to increased evidence of churning of funds. The only way an agent can be paid will now be through a trail commission that comes from the scheme itself and no other source. Mutual funds cannot charge higher expense ratios, book higher profits and then use those to pay trails either. 

Three, Sebi is allowing an exception for upfronting of commissions for SIPs but has left a stern warning that this will be reviewed if instances of misuse come to notice. Four, the maximum cost for closed-end schemes has been fixed at 1.25% and we should see the misuse of this category by some large fund houses stop. The removal of upfronting of commissions and lower costs in closed-end funds will hopefully end mis-selling in this category of funds.

Last note. I have worked in the space of retail financial products and have understood the way large financial firms work. There are two routes that firms will take to grab more money by twisting the rules of the game. One, I expect a much bigger push to the alternate investment asset category and PMS schemes. Retail investors should just stay with the mutual fund product and ignore appeals to their greed to jump into “smarter” products. Two, I expect smart exchange-traded funds to begin getting launched to side-step Sebi’s one category, one scheme rule. But there is a new Sebi in office and from what I can tell, it will be a foolhardy fund house that will stretch the spirit of the regulations.

Disclosure: the author is a member of the Mutual Fund Advisory Committee and was part of the working group constituted to look into the issue of costs.

Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation