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How Mutual Funds will Change After SEBI's Decisions?

Professor of Financial Economics and Part-time Value Investor, Transfin.
Sep 24, 2018 9:23 AM 3 min read
Editorial

SEBI's recent board meeting has brought an interesting set of rules, optimistically labelled as 'reforms'. Aside from recommendations around stock exchange rules, Foreign Portfolio Investors (FPIs), corporate Promoters, bond issuers, and commodity market participants, the most revealing suggestions have been on the Mutual Fund industry. Considering the obvious consumer interest, we thought it may be relevant to briefly walk through the core points and understand how they can potentially change the industry going forward. 

 

New rules from SEBI talk about two aspects concerning Mutual Funds. First is on the amount charged by the Asset Management Company (AMC) for its services, represented by the Total Expense Ratio (TER). Second is the commission paid directly/indirectly by investors to distributors. 

When you as an investor buy units of a Mutual Fund, you indirectly and directly pay two parties through the invested amount - the AMC managing the fund, and the distributor (i.e. your broker or financial advisor). The AMC charges a lumpsum, takes its cut and pays a commission to the distributor. You should understand these charges will negatively affect your investment return as they're deducted from your invested corpus. 

The AMC's cut is represented by something called the TER, which is nothing but the total fund costs (management fees, overheads etc.) as a proportion of the Total Fund Assets (AuM). The distributor's cut is represented by a commission, usually again expressed as a percentage of the invested amount.   

 

SEBI is pushing for "trail" commissions to be paid to mutual fund distributors rather than "upfront" commissions. Driving philosophy being that trail commissions mean distributors stay incentivized to ensure your portfolio performs well. 

Trail commissions are charged each year as a proportion of your invested amount and paid to the distributor i.e. till you remain invested. Upfront commissions in contrast is a one-off paid at the time of sale. SEBI's philosophy is that via a trail commission, the distributor stays incentivised and the scope of mis-selling and churn is reduced as in upfront commissions (where distributors are constantly switching funds to enjoy higher revenues).   

 

However, international precedents such as the Retail Distribution Review (RDR) in the United Kingdom has a different point of view, shunning away a commission based payout.

RDR was a comprehensive review introduced by the UK Regulator Financial Conduct Authority (FCA) in 2012, which reviewed the revenue model of retail fund products in the UK. It banned the use of trail commissions or in fact any commission, arguing that they serve as a moral hazard biasing the view of the distributor or adviser and is primarily used by AMCs to push sales, irrespective of client interest. A "fee driven" model was proposed, where the distributor sets and charges a flat fees, instead of AMCs paying a commission driven by the size of the invested pool. Extensive focus has been laid on the need for transparency where the consumer has to be compulsorily informed about all charges upfront in a clear and understandable manner.   

 

SEBI also set updated TER caps, reducing the costs for the consumer. 

Until now, SEBI capped TERs through the rules it had set in 1996. The Mutual Fund industry has grown manifold since then hence the regulator felt the need to reduce these caps, thereby granting some economies of scale to the end-user. The full details of the new TER cap structure can be found on pg. 2-3 of the SEBI press release.  

 

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