Will SEBI’s Proposal of Performance Linked Expense Ratio for Mutual Funds Benefit Investors?

The Securities and Exchange Board of India (SEBI) is mulling the introduction of a performance-linked expense ratio for mutual funds. It has set up a working group to review the proposal.

The expense ratio, or the total expense ratio (TER), is the fee mutual funds charge for managing various scheme-related expenses such as registrar and transfer fees, maintaining proper records of investors, custodian charges, brokerage on buying and selling securities, legal and audit fees, management expenses, advertising and marketing fees, etc.

How will the performance-linked expense ratio work?

While the details of the proposed changes have not been disclosed yet, media reports suggest that this will allow fund houses to charge higher fees in case of consistent outperformance of a scheme compared to the benchmark. SEBI will reportedly create an optional new category just like Direct Plans of mutual funds. It will lower the base fees currently charged by mutual funds, and additional charges will be applicable if a scheme consistently outperforms the relevant benchmark index. Fund houses will be allowed to levy performance incentives only at the time of redemption by investors.

SEBI is also planning to overhaul the existing expense structure of mutual funds and may soon introduce new expense ratio slabs for equity and debt schemes.

Why is SEBI pondering on performance-linked expense ratio?

The proposal to introduce performance-linked expense ratio comes in the wake of high underperformance rate of active mutual fund schemes in the last few years compared to their respective benchmarks, even over long-term time frames, which has been a cause of concern for many investors. As the expense ratio reduces the overall returns generated by a mutual fund scheme, prolonged underperformance can affect the ability of investors to achieve their set financial goals. Notably, the regulator is of the view that it is not justified to charge hefty fees from investors even if a scheme constantly underperforms the benchmark.

What is the current expense ratio structure?

At present mutual funds charge expense ratio as a percentage of total assets taking into account the assets under management and the type of scheme (equity or debt, close-ended or open-ended, and active or passive). The fee is calculated on a daily basis as a percentage of the scheme's total assets. Thus, the expense ratio will differ from one scheme to another. Every scheme discloses the daily NAV after taking into account the expenses incurred. There is no restriction on the type of expenses a scheme charges as long as the expense ratio is within the limit prescribed by SEBI.

So if a scheme handles an AUM of Rs 1 crore and incurs Rs 1.5 lakh in management, administrative, and other expenses, then the expense ratio will be 1.5%. SEBI has also prescribed the maximum TER limit that passively managed funds such as index funds, ETFs, and Fund of Funds, as well as close-ended funds must follow.

Will performance-linked expense ratio benefit investors?

SEBI expects the move to encourage funds to perform better by aligning the interest of fund managers with that of investors. But whether the move actually translates into better performance will be a challenge. Notably, mutual fund schemes are already rewarded for outperformance by way of higher inflows from investors.

There might be several possible downsides to performance-based expense ratios. It is possible that performance-linked expense ratio will prompt fund managers to undertake excess risk in a bid to generate better returns. Some schemes might resort to focusing on short-term gains, thereby compromising long-term growth. The move may also make it challenging for investors to choose between plans based on different expense ratio options.

Further, with investors increasingly opting for low-cost avenues such as passive funds, a higher expense ratio may discourage investors from investing in active mutual fund schemes.

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Does expense ratio really matter in selecting the best mutual funds?

Investors often select mutual fund schemes that have a low expense ratio. In my view, selecting a mutual fund scheme based on its expense ratio is not a prudent way.

An expense ratio is not enough to indicate whether a scheme has high growth potential. A scheme's return potential depends on its investment style/strategy, portfolio characteristics, and fund manager's experience, among other factors. This highlights that the expense ratio cannot be the sole parameter for selecting funds.

[Read: Does the Expense Ratio Matter to Select the Best Mutual Fund Schemes?]

Instead, the expense ratio should be looked at in conjunction with other criteria, quantitative and qualitative, that will help you determine the worthiness of the scheme. Here are the parameters to look into to select the best mutual fund schemes:

• Evaluate the fund's historical performance as well as performance across market phases and cycles as compared to its peers and benchmark index.

• Assess the fund's risk-reward parameters such as Standard Deviation, Sharpe Ratio, Sortino Ratio, etc.

• Analyse the portfolio quality of the fund. The fund should be well-diversified across stocks, sectors, market cap, etc., along with a reasonable portfolio turnover ratio.

• The fund house should have a significant performance record and must follow robust investment processes with adequate risk management systems in place.

• Check the qualification and experience of the fund manager and the track record of the other schemes they manage.

Before shortlisting any fund on the aforementioned parameters, ensure that the investment objective of the scheme aligns with your own risk profile, investment horizon, and financial goals.

If you find two or more funds with similar performance track record and quality of fund management, you can consider selecting a fund with a lower expense ratio. However, bear in mind that expense ratios are not static and may rise in the future.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

Disclaimer: This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision.