Fungibility: He who adds the most value, wins

A giveaway here, a tweak elsewhere, a cut there — the changes announced by SEBI last week to the expense structure of mutual funds, though they may slightly raise costs for investors, may not have an earthshaking impact.

But other proposals mooted by SEBI to ‘re-energise’ the mutual fund industry may create quite a ripple.

One such move is the innocuous-sounding decision to allow ‘fungibility’ in the total expense ratio of mutual funds.

No sub-limits

What it means is this. SEBI regulations at present lay down that a mutual fund may charge its investors a sum of up to 2.5 per cent of net assets a year as expenses. This is the total amount available to the scheme to meet all its costs — fund manager’s fee, brokerage and transaction costs on securities, selling and operating expenses, recurring distributor commissions and so on.

Fund houses, however, can’t spend this 2.5 per cent as they wish. Of this, 1.25 per cent (of assets) is to be set aside towards the investment management fees. Only the rest can be used towards running and transaction costs, selling costs and distributor commissions et al .

Under this regime, fund houses wishing to pay more to their distributors essentially had to cut corners on the other heads to do this. Or they had to pay the expenses out of their own pocket.

Use it as you please

What SEBI proposes to do is to take away this sub-limit on investment management fees. Fund houses now will be free to use the 2.5 per cent (or whatever slightly higher limits are fixed after the new rules) to expand their business in whatever way they wish.

This opens up many interesting possibilities both for investors and funds. For one, fund houses will now have much more leeway to pursue truly differentiated business models.

For instance, some funds may choose to focus entirely on differentiating themselves through performance.

They can then invest much of the 2.5 per cent limit on building a large fund management team, hiring the best talent and rewarding them for performance.

If confident that good returns will suffice to attract assets, the fund can choose to keep rewards to distributors at the minimum.

Others may choose to pursue an entirely distributor-led model. Taking the view that fund managers, in any case, cannot consistently beat the market, a fund house may rely mainly on passive products that closely mirror the index.

It may then spend a larger share of its expense limit of 2.5 per cent on attracting a wide network of distributors who can sell funds to first-time investors.

Two, this flexibility may lead to higher competition among fund houses too.

Armed with a larger kitty for expenses, smaller fund houses can now choose to compensate their distributors more handsomely than the large ones do.

Until now, with the 1.25 per cent sub-limit on investment management expenses, funds did not enjoy too much leeway in how they set commissions for their distributors.

In recent years, the widening gap between the largest asset managers in the mutual fund industry and the smaller challengers has made for a very uneven playing field.

Given that the fund business is extremely scalable, and that profits are linked directly to the size of assets managed, the large funds have enjoyed an enormous advantage in attracting talent, building a fund management team and investing in business growth.

That has made the going extremely difficult for smaller houses, leading to some funds even dropping out of the race.

While fungibility may not materially reduce the advantages conferred by scale it may still widen the choice of business strategy for small players.

Tug-of-war

Even if fund houses do not choose to go to extremes in rewarding either their fund managers or distributors, this will lead to a tug-of-war between the two key entities who are to now share the expenses pie — those who expand the fund’s assets by delivering returns to the investor and those who help the fund grow by marketing it to them.

So what is more important to the investor? Is it the returns from a fund? Or the advice and access to it, offered by a distributor?

Ultimately, the entity who adds the most value on the above will win a larger slice of the expenses pie. That cannot be bad for investors at large; which is why fungibility is to be welcomed.

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