Don’t lose sight of risks in judging mutual funds

Sebi’s proposal on linking the fee charged of investors in actively managed funds to the performance of the fund that could prove tricky to implement (iStockphoto)
Sebi’s proposal on linking the fee charged of investors in actively managed funds to the performance of the fund that could prove tricky to implement (iStockphoto)

Summary

Linking the fee that fund houses charge to their performance might be fairer, but it must not become a reason for them to take excessive risks that are not in the interest of investors

The Securities and Exchange Board of India (Sebi) has proposed several changes in the way mutual fund investors are charged. It wants the total expense ratio, or TER, to be made inclusive of all heads so that investors don’t have to contend with a slew of charges overlaid on a base expense ratio prescribed by the regulator. This would enable a transparent calculation of charges, which currently can exceed vastly the regulatory basic expense limit owing to the overheads—such as on account of brokerage, certain commissions and exit load—allowed over it. Sebi also wants the TER to be calculated at the level of the asset management company (AMC) and not the scheme and that a mutual fund house should charge a uniform fee across its schemes, not varying ones. This would make smaller AMCs more competitive while also ensuring that investors aren’t dubiously made to switch schemes from ones that pay low brokerage to those that pay more.

There are other changes planned too. But it is Sebi’s proposal on linking the fee charged of investors in actively managed funds to the performance of the fund that could prove tricky to implement. Beyond the basic expense, it wants fund managers to charge management fees only if the returns their funds generate beat either an indicative or a hurdle rate—both determined differently but with the common aim of linking it to the return of the benchmark. In simple terms, funds that outperform the category average (say the returns of passive funds, which simply mimic an index) get to charge higher management fees, while those that don’t end up losing all. Two options for implementing this are on offer; one, by deducting the basic expense charge at the time of investment and recovering the performance-based fee, if due, during redemption, and two, by deducting the performance-linked fee also in advance but refunding it at the time of redemption if the target rate isn’t met.

Broadly, the proposal, premised on a ‘charge-if-you-perform’ principle, can’t be faulted, for it makes the deal fairer for investors. But this switch from an assured-fee model to a variable one could make fund houses wary, even as they and brokerages rue losing up to 3,500 crore—the brokerage estimated to have been paid in 2022-23—owing to the all-inclusive TER formula that Sebi has proposed. To be sure, there’s a good reason for such a switch to be evaluated. Consider this, on a five-year basis, almost three-fourths of the schemes underperformed the benchmarks. That underperformance shows up in other time periods too. In other words, the investor might have been better off simply putting his money in a passive fund where even the fee is low since the expertise of a fund manager isn’t involved. Besides, surging inflows into mutual funds have lifted industry profits, but they’ve been stingy in passing on the benefits of economies of scale to investors. The issue, however, is the conflict of investor and fund interests that could arise in such a model. Faced with a ‘perform-or-perish’ situation, fund managers would be incentivized to increase the level of risk they take to generate a bigger return. This could mean making investments that could bump up short-term profits but prove highly risky in the long run. As small investors rarely go into where their money is put, this may expose them to a level of risk that they may not fully understand or are unwilling to take. Sebi will have to balance the two interests carefully.

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