Performance-linked mutual fund fee vs TER: How SEBI’s new model works and why fund houses are hesitant

At the Moneycontrol Mutual Fund Summit 2026 held in Mumbai on 30 June, Securities and Exchange Board of India Executive Director Manoj Kumar highlighted an interesting development for the mutual fund industry. He said SEBI has already created a framework that allows fund houses to adopt a performance-based fee structure, but surprisingly, the industry has shown very little interest in it so far.

“We have created an enabling provision for a performance-based incentive structure. Mutual funds are governed by Total Expense Ratio (TER) limits, but we have included an enabling clause that allows you to earn if you perform. However, neither the industry nor other stakeholders have spoken much about it,” he said.

This raises an obvious question. What exactly is this performance-fee model? How does it work, and why are fund houses staying away from it?

Here's what experts have to say.

How does the performance-fee model work, and how is it different from the expense ratio?

“In the consultation paper released in October 2025, SEBI proposed an optional framework that allows mutual funds to introduce performance-linked fees alongside the existing expense structure.

Unlike the current total expense ratio (TER), where investors pay a fixed fee irrespective of how the fund performs, this model allows a part of the fee to vary based on the scheme's performance,” said Shweta Rajani, Head of Mutual Funds, Anand Rathi Wealth.

Nitin Agrawal, CEO of Mutual Funds by InCred Money, explained that a performance fee framework already exists for other products regulated by SEBI, viz Portfolio Management Services (PMS).

“The architecture SEBI has enabled in PMS rests on four pillars — a hurdle rate, which is the minimum return required before any performance fee can be charged; a high-water mark, which prevents charging fees twice on the same gains; a catch-up provision, where managers can earn fees on the full return after clearing the hurdle in certain structures; and symmetry, which ensures investors are protected during underperformance as well,” he said.

Agrawal illustrated the mechanism with an example. If a scheme has a 10% hurdle rate and delivers a 19% gross return in a year, the performance fee would apply only to the 9% return above the hurdle, not the entire 19%. The high-water mark would then reset to the new NAV peak.

If the fund generates an 11% return the next year but does not surpass that previous peak, no performance fee would be charged despite the return being above the hurdle rate.

“This mechanism, already used in PMS, is what SEBI is now formally permitting within the mutual fund structure,” he noted.

What are the benefits and drawbacks of a performance-fee structure?

“From a retail investor's perspective, the biggest advantage is that it encourages fund houses to focus on generating consistent long-term outperformance rather than simply growing assets under management,” Rajani said.

Agrawal believes it could also lower fixed costs if designed well. “The manager only earns more if the investor genuinely earns more (above the hurdle). This is the core pitch - pay for alpha, not for mere asset gathering.”

However, both experts caution that implementation is critical.

“If it is not designed carefully, it could encourage excessive short-term risk-taking, create confusion around costs, and result in investors paying higher fees even when their own investment experience has been less favourable,” Rajani mentioned.

Agrawal added, “Hurdle rates, high-water marks, and catch-up clauses are complex for the average retail investor to evaluate.”

Why has the model not been widely adopted?

Although SEBI introduced the enabling framework, operational challenges have discouraged fund houses from using it.

“Calculating performance-linked fees fairly is operationally challenging and can create different outcomes for investors who entered the same scheme at different points in time,” Rajani noted.

Agrawal pointed to another hurdle. “India's mutual fund industry is still overwhelmingly distributor-led. A flat, predictable TER is easier to sell through the distribution channel than a variable fee structure,” he said.

How should performance-linked fees be implemented?

Experts agree that any performance fee should reward genuine alpha rather than absolute returns and should be assessed over longer periods.

“The fee should ideally be linked to benchmark relative performance rather than absolute returns. Performance should also be assessed over rolling multi-year periods instead of a single year,” Rajani highlighted.

On whether fees should be charged at the investor or scheme level, she said both approaches have trade-offs.

“Charging it at the investor level would be operationally difficult given the daily inflows and outflows in open-ended mutual funds, while charging it at the scheme level could create fairness concerns because investors enter and exit at different NAVs,” she explained.

Agrawal favours a hybrid approach. “A hybrid approach, where the scheme-level NAV crossing the high-water mark determines whether fees can be charged at all, combined with pro-rata application based on each investor's holding period, is the more scalable middle ground,” he concluded.