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SEBI’s new mutual fund regulations – what is the real impact to retail investors likely to be?

August 17, 2012 . Srikanth Meenakshi

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.

 

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11 thoughts on “SEBI’s new mutual fund regulations – what is the real impact to retail investors likely to be?

  1. A most typical ‘producer’-centric response to the issue of widening the investor base – if that ever was the objective.
    Ever since the previous SEBI regime done away with entry charges and correspondingly the commissions to the distribution channel, the industry has been shedding tears over their woes. However, surprisingly no one has made any substantive move to understand why the common investor ‘should’ invest in MFs, where neither present performance or future performance has any semblance of definitive correlation of risk-return ratio, in competition with other avenues of investments presently employed by them.
    One should try to benchmark their strategies with some of the FMCG producers who have substantially succeeded in cost-effectively reaching the consumers in [so-called] far flung markets.
    One other side of MF industry story is the distribution of the their AUMs against different asset classes. It is probably axiomatic that most of the assets they ‘manage’ is from is from the [relatively few] institutional investors and that AUMs are , possibly, therefore heavily skewed to short-to-medium debt market to meet the needs of treasury management of these institutional customers.
    Whatever their play on the equity side is, probably has not been able to fully tap the potential of already existing equity-oriented investors of these “15 Tier- I” cities and no where near developing new investors from among st these cities. Ideally speaking, before stretching their logistical efforts to the totally uncharted areas, would it not be prudent for the MF Industry to re-look at their customer segmentation and devising the the strategies to fully exploit the potential ‘demand’ from such re-defined segmented customer groups?

  2. All the steps seem to be taken from a point of view of the AMCs only and none from the end customer view. In trying to promote AMCs and their operations SEBI is missing a crucial point. SEBI made a cursory remark about few funds not performing better than benchmark also in 3 years cycles but has not taken any steps to address that. If expense ratios are somehow linked to performance of the funds there is no better fillip that gives to the AMC and same for the customer. Private industries are run on pay for performance method, why are the AMCs exempt from it? It can be argued that funds that are not performing well would loose its customer base, but what about the expenses charged to a customer who has been on the losing front and waiting for the funds to improve? Until the responsibility is fixed any steps will not lure the customers into risky products like MFs…

  3. Why nothing is written in this blog about 20 basis point increase in expense ratio. This is flat increase in expense ratio with no relation to performance or financial inclusivity. This 20 basis point increase is independent of 30 basis point related to financial inclusion.
    I came to know about 20 basis point increase through article in Business line. This blog did not agree or disagree to that statement. Can author please clarify whether it is true or false?

    1. Sanjay,

      I wrote about this in the blog – this not a flat raise. This is tied to the exit load getting credited to the scheme account and will not result in a real increase in the expense ratio.

      Srikanth

      1. Srikanth,

        If you think from the investor point of view, the expense ratio would be higher by 20 bps, and if the investor exits from the fund prematurely (may be before 1 year or so) then that amount would be credited to the fund, but investor who exits doesn’t get anything if the amount is credited to fund or given to distributor, finally that extra amount (20bps) will be taken from investors pocket only right?

        Sricharan

  4. The ‘Direct’ plan is a good option. So far, even if I’m investing directly with an MF, I end up paying for the upfront and trail comission the AMC is paying to the brokers/agents simply because it is charged to the full scheme and not by folio.

    This will boost returns for long-term investors. It’s also likely to be used more by the large tier-1 city investors, and those that are comfortable investing online directly on AMC websites. That should take away the negative impact of making the Tier-1 city investors pay for AMC costs to penetrate Tier-2 cities and towns.

    Providers like FundsIndia/parent co. can sell technology platforms to AMCs, probably on a per-transaction hosted/saas model. The earnings will be less than the upfront and trail commissions, but the unit costs are also likely to be very low if they get enough customers – should be a good margin business.

  5. So a website like Fundsindia can route its investments through another place to get lesser expense ratio for its investors ? no ?

      1. Please let us know if you have any update on ‘how the direct plans’ work / working now. If charges are less in direct plan, by .5 to 1% (of AUM), it may translate to 10% of the usual return (for debt funds) to a min of 4% of the usual return for equity funds. This is very high if we look from regular returns perspective (instead of AUM perspective).

        And as somebody has already asked, will this have any impact on Fundsindia model & hence service level?

        Thank you,
        Satyanarayana

        1. Hello sir,

          Direct plans are now available with AMCs – they will not be available through any distributors including FundsIndia. The difference in expense ratio is likely to be between 0.5% to 0.75% for equity funds.

          At FundsIndia, we are confident that our services are worth this and more for the investors. All we can do, and will continue to do, is to innovate on our services and offer the best investment platform for our customers.

          thanks,

          Srikanth

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