Capital markets regulator Securities and Exchange Board of India (SEBI) is frowning upon asset management companies bearing the expenses of passive schemes from their own books rather than from the allocated total expense ratio, or TER.

According to current norms, all scheme related expenses must be paid from the scheme and not from the books of the AMC, its associate, sponsor or trustee. Last December, SEBI had levied a penalty of ₹1 lakh each on DSP Investment Managers and DSP Trustee for taking up the expenses for DSP Nifty 50 ETF on its books.

Other fund houses which may be following a similar practice to subsidise small passive schemes, especially those with assets under ₹100 crore, have now come under the regulatory radar, said two people in the know. It is not clear what action SEBI will initiate against these fund houses. An e-mail sent to the regulator did not get an immediate response.

Small passive schemes

Currently, there are 29 passive schemes with assets under ₹10 crore, and 141 schemes with assets under ₹100 crore, data from Value Research shows. This is from the universe of 308 passive schemes that include index funds and exchange traded funds.

Such funds mimic the underlying index and low cost is their primary selling proposition. Latest data show 114 such schemes had an expense ratio of 30 bps or less, of which 27 schemes charged lower than 10 bps.

“Fund houses that run small passive schemes will find it practically impossible to recover everything from the TER. Also, if you try to charge everything to the scheme, the TER could go up and impact returns,” said a senior fund official.

“Some of the scheme expenses are fixed in nature. So, when the fund is small the expenses will be a large percentage of the AUM and what the fund is charging as TER may not be enough to meet the expenses. AMCs believe that you can subsidise some of these expenses initially and once the scheme becomes large enough it will be able to absorb all the expenses,” added another official.

Some of the expenses such as custody and fund accounting charges are fixed. Some of the expenses could also be charged as a percentage of the scheme AUM. Broking charges are also negotiated.

“In passive funds, expenses become your differentiating factor. If you charge more, your performance takes a hit. In active funds, you can say that you will perform better and cover your expenses but in passive funds there is no upside like that,” said the second official.

In the case of DSP MF, the total expense incurred by DSP Nifty 50 ETF was ₹94,182.47, which as a percentage of average AUM was 0.16 per cent. The TER charged to DSP Nifty 50 ETF was 0.07 per cent, or ₹40,944.37. The balance 0.09 per cent or ₹53,238.10 was borne by the AMC. The scheme AUM as of March 31, 2022 was ₹22.59 crore.

“This practice has the potential to create anomalies in the mutual fund industry as profitable AMCs or those with deep pockets can afford to pay schemes expenses from AMC books whereas small AMCs won’t be able to bear such expenses from their books,” the regulator had observed in its order last year.