The mutual fund story: SEBI's proposed regulatory overhaul more good than bad?

So, while a small AMC having assets up to Rs 2500 crore can charge up to 2.55 percent TER, those with AUM above 1 lakh crore will be able to charge a maximum of 1.3 percent.

“Why is the regulator looking to penalize an entity because of its scale and size” asked the head of one large AMC speaking to this writer on condition of anonymity.

The answer is probably hidden in the more optimistic reaction coming from the MF CEO of a small AMC with assets of around Rs 20,000 crore.

“The changes are a first important step in providing a level playing field. They are positive for the investor and may also usher in more foreign entities to set up MF businesses in India” says the gentleman.

While MF industry body AMFI gets down to holding discussions on the sweeping proposal, and individual AMCs also prepare to write to SEBI independently, one thing emerges clear. If implemented, the new norms will probably go a long away in curbing the mis-selling taking place with respect to NFOs as well as some of the malpractices around additional commissions for investors on boarded from B-30 (beyond top 30) cities.

As of now MFs are permitted to charge additional expense of up to 0.3 percent for inflows coming from smaller towns beyond the top 30 cities. The regulator proposes to curb this to 1 percent of application money for only new investors (identified by new PAN numbers coming in the MF ecosystem) with a cap of Rs 2000 per investor. Not just that B-30 commissions will be a part of the TER if the proposal becomes reality.

“There was rampant abuse of the B-30 provision by some of the larger distributors. Applications were being taken on wrong addresses just to earn the extra commission. This clean-up will be good for the system” says Mohit Gang, CEO at Moneyfront.

Not just B-30 commissions, but Sebi proposes to subsume all other charges including broking and transaction costs, additional expenses wrt exit loads as well as GST & STT within the total expense ratio. The market regulator argues that by paying management fee to the AMC along with broking charges, an investor is being charged twice for the advice/research used in stock selection.

Sebi is open to allowing AMCs to set up their own internal broking infrastructure to reduce operational costs. However this may not be as simple as it sounds. Most AMC heads this journalist spoke to, were of the view that executing large trades requires market liquidity and efficient order matching which a stock broker is better placed to provide.

Many also fear bearing the liability of human errors that can happen in punching trades. Considering these factors, it is likely that large AMCs may look at setting up inhouse broking arms where as mid and small sized ones may be reluctant to do so.

Sebi offers AMCs a new idea to enhance their profits – the concept of a performance-based fee which may be charged over and above a base level expense ratio if the fund does well and meets certain performance benchmarks or hurdle rates. This sounds quite fair and reasonable at a concept level, however it may not find immediate takers.

The head of a mutual fund data & performance analysis firm points out that performance-based fee models haven’t taken off too well in developed markets like the US as well because they tend to be very complex for investors to understand. Mutual Fund houses have another issue with a performance fee model and one that seems valid – won’t fund managers start taking undue risks and chase momentum to earn higher fee? Clearly performance fee is a good & novel idea but one that perhaps needs a deeper, more thorough discussion before implantation.

That brings us to the heart of the MF regulatory debate. While big, medium and small AMCs may have varying opinion on the many aspects of Sebi's 40-page long consultation paper, they are united in one aspect – the feeling that while the MF industry is possibly one of the most heavily regulated ones in the Indian financial sector, other players, specially insurance companies have an easier regulatory environment. Curbing malpractices is a must, and it’s a good idea to bring down the cost of investing, but in doing so will the regulator be squeezing small distributors out of the market?

“MF commisisons range from 0.7 – 1.8 percent. Contrast this with the average commissions of 10 -15 percent paid on insurance products” how are smaller mutual fund distributors to survive? Asks one independent financial advisor. It’s a worry that AMCs voice loudly in quiet corners away from media glare. “You run the risk of creating an environment where distributors will sell insurance or crypto or corporate FDs or even ponzi schemes – anything except mutual funds” laments one big MF boss.

Now that warning may be a bit exaggerated, but the underlying message it carries can’t be ignored.

One hopes that the MF industry will come together and debate best practices with the regulator an implement a framework that helps both – the industry and the investor. The country has come a long way with mutual funds having given a viable option to the great Indian middle class to preserve and grow it’s wealth. One only hopes that the efforts of the regulator and the MF ecosystem will strengthen that journey over the coming many decades.