Steps toward the expansion of the mutual fund industry with SEBI's proposed amendments?

Owing to the uncertainty in the capital markets, thanks to the turmoil in the Euro zone, the mutual fund industry has not been able to mobilize savings from the investors and therefore has been going through a rough patch since quite some time now. But soon they could get a respite from the capital market regulator, the Securities and Exchange Board of India (SEBI).The mutual fund advisory committee met with SEBI to bring some kind of equilibrium between the interest of investors as well as distributors with a hope to channel growth of the Industry.

Following the meeting on SEBI has proposed a slew of measures (pending notification) to increase the participation of retail investors in the mutual fund industry. We would like to share with you some important proposals and if implemented their impact on you as a mutual fund investor.

At present, equity mutual funds can charge a maximum up to 2.5 per cent as expense ratio (Expense ratio refers to a measure of costs debited by AMC for operating a Mutual Fund Scheme). Mutual funds had to allocate a maximum of 1.25 per cent as fund management fee / charge, and 1.25 percent as other expenses incurred by the AMC for marketing, distribution, operations, etc. Any expenses above 2.5% are to be borne by AMC. SEBI has now proposed to remove the sub-limits on expenses, giving AMCs freedom to allocate the 2.5 per cent expense ratio the way they want to.

This fungibility will give fund houses full flexibility to use Total Expense Ratio (TER) the way they want, while probably also compromising on the transparency and disclosures since detailed disclosures of costs incurred other than management fee will not be given.

We at Quantum AMC will not increase our current expense ratio of 1.25 per cent (one of the lowest in the industry) for our flagship product - Quantum Long Term Equity Fund and continue to believe in what is one of the cornerstones of the Quantum Philosophy to offer low cost products while maintaining transparency to our investors.

According to the new proposal, AMCs are further allowed to charge additional Total Expense Ratio (up to 30 basis points, if 30% of their net sales take place beyond the top 15 cities(100 basis points make 1%)) depending upon the extent of new inflows from locations beyond top 15 cities (Claw back of additional TER if the investments are redeemed within a period of 1 year). This means that the total expense ratios for any money coming from other than the top 15 cities (as stated in the adjoining table) can be hiked to 2.8% instead of 2.5% for equity schemes which will thus reduce investor’s capital returns. This increase in costs is excluding the increase in TER allowed by SEBI which is also discussed subsequently. We at Quantum believe that while it is important for the mutual fund industry to improve it’s geographical reach and bring in long-term retail money from smaller towns, like any other businesses it should have been the AMC who bears their expansion cost rather than the investor paying additional TER. SEBI’s intentions behind this move are good, but we are unsure if AMCs will use this additional amount to expand their penetration in the tier 2 and tier 3 cities diligently. Moreover unnecessary branch opening by the AMCs in the race to garner assets (as has been evidenced in the past) may eventually lead to mis-selling for the schemes.

In another good move, SEBI has asked fund houses to make complete disclosures in their half yearly report of Trustees to SEBI regarding the efforts to increase penetration and the details of opening of new branches especially beyond top 15 cities. However, in our opinion details about closure of branches should also be made to ensure that branch opening and closure is diligent and well thought out and not for garnering assets to top the AUM race.

In order to help enhance the reach of mutual fund products and increase the Financial Inclusion from small investors, who may not be tax payer and may not have PAN / bank accounts,cash investment up to Rs. 20,000 will be allowed to invest, subject to PMLA compliances. These investors can now get the benefit of professional investment management provided by the fund houses. However, the facility may lead to money laundering as well as increase in the operational cost and hassle of bringing that money from tier 2 or tier 3 cities to the fund house in Mumbai, where eventually it will get invested. Redemptions of such amounts may also pose a challenge.

Further, in a move to encourage long-term holding,all AMC’s would also have to now plough back their entire exit loads into the scheme during redemption(they’ll be able to charge an additional TER to the extent of 20 bps). Currently of the total exit loads collected during redemption, 1% is used to pay for marketing and selling expenses of the Scheme and any exit loads collected beyond 1% is ploughed back into the scheme. We strongly welcome this move of drawing exit loads back into the scheme by SEBI;Quantum has followed this practice of crediting the entire exit load on redemption in to the scheme since our inception. This is the second time that the practice we have started has been made the norm. In 2009 SEBI banned entry loads, something we have not charged our investors since inception. However allowing 20 bps additional TER to compensate for exit loads plough back will eventually hurt the investor, since the purpose of charging exit loads is to protect the interests of continuing investors in the scheme in case of redemption, furthermore exit loads are not meant to be used for defraying distribution costs. The total TER would now increase to 2.70% in case of Top 15 Cities as sated above and it would be 3% (inclusive of 30 bps) for Cities beyond the Top 15 Cities. The rise in TER is steep and would reduce returns in the hands of the Investors.

12.36% of 1.25% (being the management fees) of Total Expense Ratio (TER) charged by any fund house as of today is the service tax borne by the investor as a part of Total Expense Ratio. To enable the mutual fund industry to be in line with all other industries, where service tax (12.36 per cent) is borne by the end-user,SEBI has decided that the service tax payable on investment management fees should be charged to the scheme and be borne by investors over and above the TER of 2.70% or 3% as the case maybe.

Meanwhile,SEBI has capped brokerage and transaction cost chargeable to the scheme for execution of trade at 12 bps in case of cash market transactions and 5 bps in case of Futures & Options (F&O) transactions. The intention of SEBI by this move seems to reduce transaction cost associated with cost of investments.It is not clear as of now with regards to the treatment of brokerage and transaction cost beyond 12 bps if incurred by any AMC, is still subject to SEBI’s amendments to be announced, as to whether the excess has to be borne by the Scheme or can be debited to Total Expense Ratio (TER).

However, since the cost of investments is directly co-related to the investment philosophy followed by the AMC which is a function of portfolio turnover ratio, it is unfair to prescribe similar brokerage and transaction cost for all. The current brokerage is around 15 to 20 bps that a broker charges. More the portfolio turnover ratio, more the churning of securities and therefore more the brokerage costs. While this will make the broker happy, they would eventually agree to negotiate and lower their brokerage costs on account of a higher portfolio churn. But a Fund with lower portfolio churn ratio who believes in 'research' and 'buy & hold' philosophy will not meet the transaction criteria, thus brokerage costs will not be lower and therefore the AMC will have to bear the costs of industry inefficiency. Here a Fund is being penalised for following good practices. One need to understand that lower volumes of portfolio transaction eventually pushes down the cost but the higher volume churn may not necessarily benefit the investor but will increase costs.

For strengthening regulatory framework for mutual Funds,SEBI has stated that asset management companies (AMCs) are to make monthly portfolio disclosures on their website. Further, to ensure fair treatment to existing investors of Mutual Fund schemes, SEBI has decided to harmonize applicability of NAV across various schemes based on the day on which the funds are available for utilization, for an amount equal to or more than Rs 2 lakh.

To avoid differential treatment in the same scheme to different classes of investors, all new investors will be subjected to single expense structure under a single plan (its confusing how this will be implemented for investors from Top 15 Cities and investors from other than TOP 15 Cities since its proposed to have two different TER). However, to promote direct investment and to pass on the benefit of lower ‘procurement’ cost to the investor,SEBI has mooted the idea of different plan for direct investors in a mutual scheme with lower expense ratio. While it will help investors to save the additional cost they pay for the distributor’s services; it will not be operationally difficult for fund houses to manage this. The real challenge here is how the AMCs will pacify the distributor in case a customer introduced by him makes additional investment into the direct plan. As India’s 1st and only direct to investor mutual fund, we are the only fund house who have actually realized the potential of direct investment. At Quantum Mutual Fund, we opted to walk a road different from the rest. With the investor as ou primary focus, and investor’s benefit as our only priority, Quantum Mutual Fund refused to adhere to the ‘non-transparent commission paying style' of promoting its funds. Our low cost approach and zero distribution cost consecutively helps us in our scheme performance, therefore reflecting positive impact on investor’s return.

While confronting the issue of mis-selling,monitoring would be done through an evolved system of ‘product labeling’.Product labeling basically means creating a categorisation system that helps investors make sense of the large number and variety of funds that are available. This system will bring uniformity in fund categorization, which will eventually facilitate confront the issue of mis-selling. The investor will have a better understanding of the scheme that he proposes to invest in, while also help in tracking peers.

SEBI has also asked the Mutual Funds to set apart a portion of the asset management fees annually for investor education campaign.

This is to ensure greater focus on investor education. Path to Profit is our way to educate investors. We intend to travel across various cities in India and guide investor's, both existing and potential through their investment process. 'Path to Profit' is our opportunity to interact with them and understand their investment needs. Our financial experts help them achieve their financial goals with two simple rules - a long-term approach towards investing backed by a disciplined investment process.

SEBI’s recommendation of mutual fund investments being a part of Rajiv Gandhi Equity Savings Scheme could assist AMCs in attracting new investors in capital markets. Moreover, SEBI has also felt the need and has requested the Mutual Fund Advisory Committee to develop long term policy measures for the Mutual Fund Industry which inter alia would include all aspects-including enhancing the reach and promoting financial inclusion, tax treatment, obligation of various stakeholders, etc.

SEBI has also introduced different levels of certification and registration for distributors that would be required depending upon products and services offered.Other than just simplifying the distributors' registration process, in order to energize the distribution network and increase the ‘feet-on-street’ in distribution,the regulator has also proposed to widen the distributor base by now including postal agents, retired officials from banks, government, teaching fraternity, etc. for distribution of simple products. While this will energize the distribution network, but there exist a potential risk of mis-selling of schemes to the investors due to the lack of knowledge and understanding by these proposed individuals of the complexities of the current mutual fund products besides working for targets and incentives which will not be disclosed to the investors. The potential risk as stated above is not new as the Industry keeps battling the same even now. While these are the changes proposed for distribution network,the Board has also approved SEBI (Investment Advisors) Regulations, 2012 and thereby providing framework for registration and regulation of Investment Advisors. All individuals, corporate body and partnership firms engaged in the business of providing investment advice to the investors for consideration will now be required to be registered and regulated under these new Regulations. This intends to clear the confusion among investors about wealth managers, private bankers, distributors and portfolio managers and like by mandating the unilateral use of the term 'Investment Advisors'. This hopefully would help us resolve two areas of conflict of interest prevalent today. As distributors pay a dual role by being an agent of both the investors and the AMCs, he will get paid by both the parties. Such divided loyalty is not the best interest of stake holders and results in a situation where the distributor is loyal only to himself, probably churning investor's portfolio and squeezing more commission from the manufacturers of funds.

With an aim to revive the mutual fund industry, market regulator further promised to introduce a comprehensive policy in the long-term to address all aspects including tax issues; financial inclusion, etc. which could pave the way for more reforms and the Industry attract more investments

Mutual Fund Advisory Committee of SEBI would recommend long-term policy measures after wider consultation with all the stakeholders in a reasonable time frame.

Though one awaits the fine print of the amendments, for an industry and its investors the announcements from SEBI should be implemented in the right spirit. The announcements reflect an effort on the part of the Regulator to address some of the challenges faced by the Mutual Fund industry. SEBI has, in the past, played the role of a regulator of the Mutual Fund industry and has introduced many pro-investor measures like the abolition of Entry Loads for all investments. We believe that while in the current developmental phase mutual fund Regulator SEBI has largely played the role of the developer of the mutual fund industry. Over a period of time it should also ideally take care that - the benefits of such measures are not misused in terms of mis-selling, churning or zeal to get more corpus which can have bad impact on the overall industry.

Once again we would like to thank you for your unwavering support in our endeavor to achieving our Vision, which is "To stay focused on the needs of our investors and be India’s most respected mutual fund house by adhering to traditional values of simplicity, transparency and integrity while continuing to deliver steady performance over the long term".

Read the full press release here at SEBI’s website