Decoding new MF expense rules: Fund houses now free to allocate

• Posted by Sindhuri G August 30, 2012 - Filed in Business - 2,027 views

  The decisions announced after the Sebi board meeting last week provide the much-needed breather to asset management companies (AMCs). There are three key decisions about expenses that impact investors and AMCs.
  
  The first is the fungibility in the total expense ratio. The maximum expense that an equity scheme can charge to an investor is 2.5% (2.25% for debt funds). The rate applies in slabs: 2.5% for the first Rs 100 crore, 2.25% for the next Rs 300 crore, 2% for the next Rs 300 crore and 1.75% for the balance. When a fund reaches a size of, say, Rs 1,000 crore, the maximum chargeable expense given these slabs is effectively 2.05% ( Rs 20.5 crore on Rs 1,000 crore).
  
  The only internal limit in the expense ratio was the amount the investment manager, the AMC, charged a scheme. In a Rs 1,000-crore fund, the AMC earned 1.25% on the first Rs 100 crore and 1% on the remaining Rs 900 crore, or a total of Rs 10.25 crore (1.025%). If the Rs 1,000-crore fund achieves economies of scale and is able to control all the remaining expenses at 5 crore, it can only charge a total expense of Rs 15.25 crore (maximum Rs 10.25 crore to the AMC, plus 5 crore other expenses). The effective expense ratio of 1.525% is smaller than the 2.05% that regulation actually permits the fund to charge to the scheme.
  
  Sebi will allow charging expenses to the scheme without internal limits. This simply means that AMCs will now make more money out of the funds they manage. They can charge the scheme the maximum permissible expense, and take whatever is left after meeting other expenses such as investment management fee. Those who have interpreted this change as being neutral to investors seem to have missed this point. There will now be no need for a mutual fund to charge a lower fee, except for purely competitive reasons. The artificially-lower expense ratio charged by funds, due to the cap on investment management fee, will go. Debt funds may remain low-cost due to the direct impact of expenses on yield; but in principle, the leeway to charge more within the unaltered overall limit has increased.
  
  AMCs are likely to use this new-found flexibility in two innovative ways. First, they can charge the maximum permissible expense ratio and decide to pay all the expenses from their own books. Today, direct expenses are charged to the scheme, and employee and administrative costs are met by AMCs. Fungibility of expenses allows better scale-economies if AMCs pay service providers for total assets under management (AUM), instead of managing expenses at a scheme level. This reduces several expense ratio management semantics and accounting hair-splitting. AMCs will have higher outlays for advertisements, promotions, commissions and expenses they like to incur as a fund house. Second, charging service tax to the scheme would reduce the amount of fee available to AMCs. They could take all the permissible expenses into their books, pay service tax, but after credits for service tax paid to all service providers, thereby reducing overall incidence of service tax and optimising actual expenses.
  
  The second decision about expenses is the incentive for geographical expansion. If 30% of a scheme's new inflows are contributed by locations outside the top 15 cities, expense ratio can be increased by 30 basis points (bps). Lower contribution means proportionately lower expense ratios. The same board meeting has held that schemes should have a single expense structure, except for a direct investment facility. Therefore, higher expense ratio will impact all investors in the scheme, including those from the top 15 cities. They will effectively cross-subsidise the expense incurred to mobilise funds from other locations. There is also a provision for claw back, where the expense ratio will be reduced if such inflows are redeemed within a year. In a mutual fund, incoming, existing and outgoing investors have to be treated equitably. Incoming investors from other locations will reduce the net asset value (NAV) of investors from the top 15 locations, as expense ratio goes up; redemption will have the reverse impact due to the claw-back provision. NAVs should not be impacted by inflows. In a mutual fund, this rule is sacrosanct.
  
  The third decision pertains to exit loads. Exit loads are credited to a separate account and typically used in sales, distribution and marketing. Exit loads above 1% are credited to the scheme. Sebi has now proposed crediting the entire exit load, and allowed 20 bps of additional expense. Exit load is not uniform across schemes or holding periods. Expense ratio is computed on schemes' assets; exit load is computed on redemptions, a subset of the assets. Staying investors take a 20-bp hit on expense if outgoing investors pay an exit load that is smaller in amount, which is most likely during normal times.
  
  Sebi will soon issue detailed circulars. But the simple recognition that AMCs have been bleeding and need help to grow the business is a step in the right direction. It is now up to the AMCs to use this leeway to achieve better size-economies, and not fritter it away paying distributors, yet again.