After weeks of deliberations, SEBI has come out with its new regulations for the mutual fund industry. Currently, it is a press release which means we only get the outline of the changes proposed. Soon, this will be followed by a circular (more than one, likely) which will contain more details. The circular(s) will be analysed by the mutual fund compliance officers (and probably, AMFI) and they will come out with guidelines of implementations which is when we will really know the true import of the changes from yesterday.
(A good summary of the SEBI announcements yesterday is here in LiveMint and full press release here at SEBI’s website)
Nevertheless, there are sufficient details (more in some areas than others) in the press release to analyze the impact on the retail investors. The headline news in various media news reports is that the expense ratio has gone up for the mutual funds. While this is technically true, I believe the actual impact on the investor would be less than how it is projected.
There are three or four line items in the press release that warrant closer look in this regard:
Firstly, higher expense ratio for promoting MFs in Tier II cities – SEBI has proposed that an MF can charge up to 30 bps (one bps is one hundredth of a percent, so 30 bps is 0.30%) more in its total expense ratio towards promoting mutual funds in places outside of the top 15 cities. However, this raise is tied to the goal of getting 30% of the new inflows from these places. If an AMC gets less inflows, they will be allowed to charge only up to the % of inflows they get – that is, if 5% of new inflows to a scheme are from these places, then the expense ratio will go up by 5 bps only.
Currently, the inflows from these Tier II or lower places are negligible. Bringing them up to 30% is a huge task and it is very likely that for the first few years at least, this increase will be in the 5 to 10 bps range at best.
(As an aside, I cannot help but note that this is a very “Indian” regulation – asking the top tier cities’ investors to directly bear the cost of getting tier-II cities’ investors into the big tent of mutual fund investing. I cannot imagine a regulation like this coming out of SEC in US – imagine asking investors in New York to pay extra so that some one in Wichita, Kansas can invest in mutual funds! Fuggedaboutit! 🙂 )
Secondly, the service tax pass-through. SEBI has ruled that service tax that has thus far been borne by the AMCs can now be passed through to the investors. Basically, this is how it is done in all other industries. Anybody who has received an invoice for a service will be familiar with the “Service tax extra” caveat to the quoted amount. AMCs provide a service (fund management service) to investors and will rightfully start charging the investors the requisite amount. This charge, however, is apparently likely to be 2-3 bps (according to the press release). My thought is that this 2-3 bps is more likely to be the blended overall impact across schemes. For equity schemes, it is likely to be higher, more in the 7-8 bps range for big funds and 10-12 bps range for smaller funds (service tax is charged on the amount that an AMC gets to keep from the expense ratio, so it will differ from AMC to AMC and scheme to scheme).
The service tax impact will also be affected by the new “fungibility” clause which allows AMCs to be unfettered with regards to how it wants to manage the expense ratio. The amount that will be subject to service tax will depend on how much the AMCs choose to charge from the expense ratio.
The third item in the press release that warrants attention with regards to investor bottom line impact is the clause about exit loads. However, this is likely to be a zero sum game between the AMC and the investor. The press release states that the exit load charged to premature exit investors will now need to be credited back to the scheme account (and not the AMC account), and an equivalent amount (up to a limit of 20 bps) can be added to the total expense ratio to compensate for the loss to the AMC account. What this means is that the credit of exit load to the scheme account will be balanced by the expense ratio. So neither the AMC nor the investor stands to gain.
So, why make this change? Well, there is a third person in the equation that is missing from the paragraph above. And that is the distributor. Thus far, the distributor (such as your humble correspondent) was getting paid by the AMC in the form of upfront commissions by the AMC from the exit loads. Since that money will now come distributed across time in the form of expense ratio, this commission will now go away and probably be replaced by a slight bump in the trail commission. This move by SEBI is to discourage “churning” by distributors to earn upfront commissions.
So, these are the salient line items in the SEBI announcement that merits attention from an expense perspective. The real impact to the investors at least in the initial years will be limited – likely to be between 10-15 bps bump in the expense ratio. It will be determined by two factors – what the service tax is computed on and how successful AMCs are in achieving their social target of MF penetration.
There are several other points in the SEBI press release that warrant mention. However, there are too few details that it would be premature to comment upon. There is a clause about a “direct” plan with lower expense ratio, but it is not sure if it would be mandatory or how much lower the expense ratio would be for such plans.
Like I said, we will have to wait for the circulars, the AMC interpretations, the AMFI rulings etc. to get the final picture.