At Investors’ Expense

The cost advantage that mutual funds offered to investors has been slightly reduced to“revive” the fortunes of the industry.

The Securities and Exchange Board of India (Sebi) recently changed rules to encourage the mutual fund industry to increase its reach beyond the large cities. The result is a slightly higher cost for investors, but not as high as it was before Sebi banned entry load, an upfront 2.5% deduction from the invested amount that was used to pay commission to distributors.

For instance, at present, for every Rs 100 invested, Rs 2.5, or 2.5%, can be deducted for meeting expenses related to fund management, marketing, etc. Now, the deductions towards expenses (also called expense ratio) will rise by 15-50 paise (15-50 basis points or bps) for every Rs 100 invested.

We explain the impact of these moves on investors.

A 20 bps rise in expense ratio: This will compensate mutual funds for ploughing back the money raised from exit load into the scheme instead of using it to meet expenses.

Mutual funds charge 1% exit load if the investment is redeemed before one year. The amount raised is used to pay for expenses incurred by the funds.

Now, Sebi has asked fund houses to put the proceeds back into the scheme and as a trade-off allowed a 20 bps increase in expense ratio.

Sebi, however, says that this 20 bps rise will not affect investors. Akshay Gupta, managing director and chief executive officer, Peerless Funds Management Company, says,“It is estimated that 20% assets are churned within a year and hence the schemes can charge 20 percentage points extra. This will be offset by the 20 percentage point increase in returns for customers due to ploughing back of exit load to the extent of 20% assets.”

A 30 bps increase in expense ratio: This will impact investors in small towns (other than the top 15 cities). The aim is to encourage mutual funds to reach out to investors in smaller towns.

However, fund houses will be able to charge the higher fee only if 30% of new money or 15% of total assets, whichever is higher, comes from these towns.

As on June 30, only 13% industry assets came from cities that are not in the top 15 list. Around 74% assets came from the five metros—Mumbai, Delhi, Bangalore, Kolkata and Chennai.

Out of five top fund houses in terms of size, only UTI gets more than 20% assets from cities other than those in the top 15 list. For UTI, the figure is 24%, while it is 20% for HDFC and Reliance Mutual Fund, 16% for ICICI Mutual Fund and 12% for Birla Sun Life Mutual Fund.

The expense ratio for investors in smaller towns will go up by 50 basis points.

Service tax to be borne directly by investors: As of now, service tax on fund management is part of the total expense ratio, which is capped at of 2.5% net asset value.

As service tax in all other industries is borne by the customer, in mutual funds, too, the service tax on fund management fee will be paid by the investor over and above the expense ratio, Sebi has said.

The fund management fee can be up to 1.25% value of the fund. A service tax of 12.36% of the fund management fee thus comes to 0.15% of the scheme’s assets. This is the additional burden investors will have to bear as service tax will no more be part of the expense ratio.

Nehal D Sampat, associate director, PwC, says when the government introduced service tax, the intention was to levy it on those who receive the service. “Since mutual funds already had an expense ratio, Sebi decided to include service tax in that. Due to this, mutual funds were losing a part of the expense fee. With service tax being charged separately, fund houses will have more flexibility in allocating funds for other expenses,” he says.

No sub-limits within expense ratio: Within the 2.5% expense ratio, Sebi had put sub-limits on different expenses such as 1.25% on fund management fee, 0.5% on distributors’ fee, etc.

It has proposed to do away with these sub-limits to give fund houses more flexibility in using funds. This will help the funds in managing costs better.

However, some believe this will make funds less transparent. “This will probably compromise transparency as the funds will not give detailed disclosures of costs other than the management fee,” says Jimmy A Patel, chief executive officer, Quantum Asset Management Company.

But should it concern you? Yes, because if the fund house charges a higher fund management fee, the service tax will go up. Remember that you will have to pay service tax separately now.

Lower expense fee for direct investors: This is to reward those who invest without the help of agents or financial advisors. The extent of the cut is not known yet. At present, 0.50% goes towards payment of commission to distributors/agents.

Sebi has also decided to do away with the differential expense ratio for different classes of investors. Institutional investors such as corporate houses, banks and high net worth individuals pay less because of the sheer size of their investments. In future, they will not be able to avail of lower charges by default. Instead, they will have to apply under the direct investment route.

Transactions up to Rs 20,000 in cash: This is another step towards reaching out to small-town investors who do not have bank accounts.

“This may increase acceptance of mutual funds in smaller towns, where a large part of economic activity is cash-based,” says Akshay Gupta of Peerless Mutual Fund.

For this, fund houses will have to develop a system for cash receipts and payments. Nehal D Sampat of PwC says cash payments to investors could be an issue and might require building of payment infrastructure covering investors in small towns.

Product labelling: Sebi has proposed to evolve a system of ‘product labelling’ based on simplicity and volatility of returns.

According to a Sebi circular, a new category of ‘Simple and Performing’ funds would be created, which would include diversified equity schemes, fixed maturity plans (FMPs) and index schemes.

These schemes could be distributed by a new cadre comprising post-office agents, retired government and semi-government officials, and retired teachers.