The surge in inflows over the last few years has resulted in the larger mutual fund houses reaping the benefits of economies of scale as they could service the growing asset base with relatively lower incremental growth in expenses. But these benefits have not been passed to investors and SEBI is seeking to address this through its recent consultation paper on Total Expense Ratio (TER) of mutual funds.

The regulator found that pre-tax profits of AMCs grew 154 per cent from 2016-17 to 2021-22, with eight large AMCs, having almost 75 per cent of the total AUMs seeing a higher 173 per cent increase. In this period, their profit margins too grew steadily from 43 per cent to 70 per cent. But despite these stellar numbers, TER is close to regulatory limits for equity funds. In debt schemes, which corporates and institutional investors prefer, the TER is much lower than the prescribed upper cap.

Besides, regular plans are worse off with permissible additional expenses loaded over and above the base TER, which already includes distributor commissions. Little wonder then that regular plans of actively managed schemes fare much worse than direct plans, across time frames. The proposals in the paper addressing the above anomalies are a step in the right direction to protect the interest of individual investors.

Also read: SEBI on expense ratios: Four ways investors are being short-changed by mutual funds

SEBI proposes to level the playing field by bringing an all-inclusive TER without differentiating between base expenses and others. This will have a check on excessive additional/dual expenses in the pretext of brokerage and research costs charged to funds as well as curb the misuse of allowance for higher expenses for inflows from B30 cities. Since AMCs enjoy economies of scale linked to their overall asset levels (rather than at the scheme level), the AUM slabs for the TER chargeable now are also proposed at the AMC level instead of at scheme level slabs, as is the case now. Thus, larger AMCs will have to pass on lower costs to investors.

An impact analysis by SEBI of the proposed slabs show that equity, hybrid and solution-oriented schemes will benefit from reduced expenses. AMC level TER will also discourage distributors from switching investor monies in existing funds to NFOs, which don’t have a track record. In the current scheme of things, AMCs can charge higher TERs in NFOs and can thus give distributors higher commission to attract flows into NFOs. Direct plans that anyway cut out distributor commissions can enjoy further cost reduction from this move and can still be the first choice for informed investors.

SEBI is also raising the larger question of whether fund management fee must be linked to manager performance in this paper. This is, however, an idea whose time may not come soon. The formulas suggested by SEBI for evaluating the fund’s outperformance may be difficult to implement at individual investor level and it is moot whether it will be beneficial for investors. A simpler way out is for investors to be nimble on their feet and follow the outperformers or move to passive funds.