The SEBI chief could not have picked a better time to warn the Indian mutual fund (MF) industry on exercising self-restraint on costs and distributor commissions. With an upbeat stock market luring retail investors to pour record sums into equity funds over the last year, doubtful industry practices such as numerous new fund offers, thematic products and compulsory investor lock-ins have made a comeback. In the race to gather assets while the going is good, fund houses have also been shelling out upfront commissions as high as 6 to 7 per cent for aggressive distribution pushes. Such commissions, even if funded out of the asset management company’s pocket (they must be as SEBI has banned entry loads) can give rise to mis-selling and a poor return experience for investors if they end up buying the wrong product at the wrong time. The industry can ill afford this, given that investor confidence in MFs has revived after a long hiatus.
High commissions can also come back to haunt investors after a while in the form of higher annual fees or exit loads. There is already evidence of such pass-through with the annual expense ratios for some equity funds nudging 3 per cent, from 2 per cent around three years ago. Rising fund costs in India contrast with global trends, where actively managed funds are under enormous pressure to lower their fees. In the US, for instance, even though the Securities Exchange Commission imposes no cap on fund fees, active funds levy an average expense ratio of about 1 per cent. Even this is being deemed too high by investors, who have been migrating wholesale to passive index funds with fees of 10 to 20 basis points. In India, the limited penetration of index products and the ability of active managers to trounce indices by big margins have made costs a non-issue; but if markets turn or if the margin of out-performance narrows, investor returns are bound to hurt. While SEBI can clamp down further on expense limits, this is undesirable given that the mutual fund industry competes for a share of the investor’s wallet with products such as insurance and corporate deposits, which pay even higher commissions.
Instead, SEBI can shield investors from escalating costs by actively promoting direct MF plans, which allow investors to bypass distributors. The fee differential between direct plans and regular ones remain hazy, and SEBI should tighten disclosure norms. Of course, SEBI also has to acknowledge that part of the recent escalation in fund costs is of its own making. Its rules allowing funds to levy 30 basis points in extra charges if they source assets from smaller cities, and the additional 2 basis point spend on investor awareness initiatives, have added to fund costs for retail investors. It is unfair that consumers should bear the costs of such inclusion initiatives; SEBI should consider using its own investor protection fund for this purpose.