Need to think out of the box on fund expenses

For quite some time, we have been debating over direct versus distributor, lowering the cap on expenses, additional expenses for selling mutual funds to B30 locations (beyond the top 20 locations) and expenses for compensating exit load, among other issues. The ultimate variable for these exercises is the expense ratio that the asset management company (AMC) is allowed to charge, and the underlying theme is that lower the expenses charged, higher the return to the customer. However, what’s being missed out in the debate is the performance of the fund. When an investor enters a direct plan and the fund underperforms the peer group, she is left only with the psychological satisfaction of having paid a relatively lower charge to the AMC than the regular plan customer.

Let us look at the issue of mutual fund expense ratio from a different perspective: performance-based variable expenses. While implementation of a model for variable expenses will be complicated and subject to debate, let us start the debate now. The timing is opportune as the Securities and Exchange Board of India (Sebi) is contemplating bringing down expense ratios further. I propose the following model of charging expenses:

• There would be a minimum out-of-pocket expense allowance, subject to limits, depending on the nature of the fund like equity, debt, hybrid, exchange-traded funds, or others. This would be common to direct and regular plans and there would be no distribution commission.

•There would be a fund management margin allowance, depending on the fund’s nature—higher in equity funds than in debt funds, and lower in passively managed funds than in actively managed ones. This component would be higher to include distributor commission in regular plans.

•Then comes the tricky part: performance-based expense allowance. There are a few ways in which this can be done. One could be to measure performance against a securities basket-based benchmark like Crisil index for various fund categories. Or with a peer group-based benchmark like Amfi category-wise performance indicators. The third one is the “bonus expense allowance” component based on performance. It will be debated which benchmark is better, but since investors compare returns more with the peer group, it may be a peer group-based formula, for example, first quartile or second quartile performance in the peer group over a long period such as 3-year rolling returns.

The advantage will be that the customer will be paying a higher fees to the AMC only if she is taking home a higher return. The rationale is that it is about sharing a small part of the returns with the AMC for superior performance over a reasonably long period, and not just about avoiding the distributor to pay less to the AMC.

There will be competition among the AMCs for the third variable—to charge a higher expense to the fund—not only to earn more for themselves but also to remunerate the distributor. While competition has its advantages, it has pitfalls too. The pitfall could be that distributors will run after funds that have prospects of higher returns, as that will allow them higher brokerage. That, in turn, may lead to incentivising churning by distributors. The answer to that could be the following:

•The third variable-based expense allowance would not be reset frequently; the frequency could be as long as, say, one year or two years. In that case, one week or one months of outperformance by one fund may not attract distributors as they would know another week or month of underperformance would even it out.

•The brokerage payout from the second and third variables would be demarcated and cannot exceed pre-defined limits. The payout from the third variable would be at long intervals.

There could have been another pitfall of competition for the third variable, that of taking undue risks in the fund. However, with the new fund categories defined by Sebi, it is now uniform across AMCs. For example, in a large-cap fund, they can only buy large-cap stocks and not small-cap stocks.

Variable performance-based expenses is not a new concept. It is there in certain customized products for high networth investor segment, where there is a threshold performance and if the return is above that, there is profit sharing at a predefined ratio. For example, if the threshold is 12% and the profit sharing ratio is 80:20, and the product delivers 14%, then of the 2% (above 12%) 80% goes to the client and 20% to the manager. This can be tried in a segment like funds, to make remuneration more equitable.livemint