A tightrope act

The Sebi board made some significant decisions in its latest meeting regarding regulation and development of the mutual fund market. While Sebi is the securities market regulator, the preamble of its parent Act also envisages a developmental role for it. That doesn’t play out very often though, but the mutual fund industry is an exception. In the board meeting Sebi has very delicately balanced its two roles and the tension between the two is clear to those who have read commentary on the issue. Many have criticised Sebi for not going far enough while others have slammed it for going too far. In simple terms, Sebi needed to balance the interests of investors by keeping a ceiling on expenses that could be charged and play a developmental role by increasing the ceilings so that funds are sold by distributors. The latter is clear to those who have observed how distributors have abandoned MFs in favour of lucrative products. This column takes a granular look at Sebi’s moves. 

Sebi has increased the permissible expense ratio that asset management companies (AMC) charge to funds (and to unit-holders). Clearly, higher expenses for funds take money from investors and by increasing the expense caps, one could argue, in the absence of other facts, that Sebi has taken an investor-unfriendly action. But the context is crucial. The MF industry has been injured on several counts, many of which were driven by Sebi’s attempts to curb mis-selling of funds. For instance, Sebi stopped the charging of an entry load on funds, which was collected and given to distributors, because it found that this benefit creates the opportunity to mis-sell by pushing investors to sell an existing fund and buy a new fund, solely so that the distributor gets additional commission. In regulatory parlance this is known as churning. 

Distributors got less commission thanks to barring of entry loads, but they continued to get double-digit commissions on sale of other products like insurance-linked funds. Since funds are sold rather than bought, that is, people buy funds based on the marketing effort of distributors rather than purchase it otherwise, this led to the abandonment of the MF market by distributors. On the other hand, because of the rather dismal equity markets that were, in turn, reflected in MF performances, investors who lost money because of an adverse market also chose to abandon the MF route as well as other equity investments. The result has been a steady decline in assets managed by mutual funds over the past several years. 

Sebi, thus, had a delicate task of getting more distributors to play ball without running over the investors, whose protection is the regulator’s key task. It increased the ceiling in expense ratio by 0.20% as its chosen method of altering the current cap to incentivise the distributors who are expected to now sell the fund units. The second decision is that it has allowed an increase in expense cap charged by the AMC to the MF if it is able to garner funds from small towns. Where an AMC is able to raise over 30% of its funds from beyond the top 15 cities, it would be able to charge an additional 0.3% fee. This additional expense will not be binary. So, for example, if an AMC gets only half the targeted amount (15% of the fund value) from smaller tier cities, it would still be permitted a 0.15% increase in expenses. Thus an AMC would get a higher expense if it has the ability or takes the pain of going beyond the lucrative large cities. This move has two impacts. Investors will need to bear a larger burden because the higher expense will come from their pockets for compensating the AMC. However, the amount of incremental expense is not large and is unlikely to substantially impact investors adversely. From the AMCs’ perspective, there are both costs and benefits involved. Clearly, the large cities are the easy markets with higher disposable income. To go beyond them would require substantial expense and consume time, though trying to tap this untapped market would come with the benefit of a higher expense ratio. Each AMC will need to see whether it is able to generate more income compared with costs incurred in penetrating markets and then try to move into semi-urban and smaller urban markets. While many smaller AMCs will protest at not getting a share of the pie, the dessert is only available to those who are willing to put in that extra effort and go beyond the low-hanging fruit offered by large cities. 

The third decision with respect to the expense ratio of MF AMC is also a good move. Till now, there was a cap on expenses an AMC charged and for which it could seek reimbursement. Not only that, Sebi prescribed how the expenses would have sub-caps. By making expenses fungible, Sebi has removed an area of pointless over-regulation within the overall regulation of capping of expenses. In other words, the AMC can charge any expense to the MF for managing its portfolio so long as it is within the overall cap prescribed by Sebi. 

Fourthly, besides increasing expense caps, Sebi has mandated that where an investor is charged an exit load (a fee, usually on an early sale of the unit by an investor within, say, one year of purchase), it is credited back to the fund scheme (meaning other longer-term investors) instead of it going to the AMC. This is clearly an investor-friendly move that will ensure that distributors who make investors pointlessly churn by buying and selling MF units will not indirectly be incentivised for committing fraud (Sebi regulations term churning as fraudulent). Till now, every time a distributor made an investor sell prematurely, an exit load went to the AMC that, in turn, had more money to pass on to the distributor, thus incentivising this  behaviour. The incentive now goes away and short-term investors will be penalised.

Fifth, it was decided that all new investors will be subjected to a single expense structure under a single plan. However, where an investor came directly without the help of a distributor, the fund is expected to have a separate plan for direct investments, with a lower expense ratio. Since a fair part of the AMC fees is, in turn, paid out to distributors, where this commission is not paid to a distributor because the investor came directly, the benefit should not accrue to all unit-holders but only to those who came in directly. This is a fair segregation of plans, though it may be a bit challenging creating two mirror plans, one with a higher, another with lower expenses. 

There are some other changes, like permission to invest up to Rs.20,000 in cash and without a PAN card, passing on of the service tax burden to investors, and clawback of compensation where non top-tier city investment is redeemed within one year (or reversing compensation where small-town transactions are not genuine). In the longer run, Sebi will also push for setting up a self-regulatory body that will oversee the community of distributors of MF units and evolve a long-term policy on regulation of MFs including enhancing financial inclusion, better tax treatment etc. 

Overall, despite criticism, Sebi has probably played a fair Aristotelian middle path. On a lighter note, this can be deduced from the fact that both criticisms have been at equal decibel levels.