SEBI Proposes a Uniform Expense Ratio for Mutual Funds to Curb Mis-Selling

Swetha Dhinesh

02 Mar, 2023

The Securities and Exchange Board of India (SEBI) is considering the changes in how mutual funds charge investors for their total expense ratio. The amendments being considered aim to crack down on mis-selling and mandate that mutual funds apply a uniform expense ratio for all schemes, including equity and debt. Regardless of the size or kind of scheme, a fund house must charge a uniform expense ratio for all equity funds. Mutual funds currently have the freedom to establish their fees however they see fit.

If this plan is approved, a fund house, for example, will be required to charge a uniform expense ratio for all its equity funds. A mutual fund must have a uniform expense ratio across all of its ten schemes if it manages 50,000 crores in equity assets. In this blog, we’ll discuss the expense ratio in mutual funds, the current ratio limit and the reason for the new proposal for a uniform expense ratio for mutual funds to curb mis-selling.

Expense Ratio

The annual maintenance fee mutual funds charge to cover their costs is known as the expense ratio. It covers the fund’s annual running expenses, such as management fees, allocation costs, advertising expenditures, etc. The value of an expense ratio is based on how big the particular mutual fund is. A fund that operates with fewer financial resources must devote a specific amount to effective management. In relation to the total quantity of funds available, this raises the relative worth of the expenses.

Contrarily, the amount set aside to cover expenditures in large-cap mutual funds is less than the value of all assets. As a result, the expense ratios have an inverse relationship with the mutual fund size.

Every good or service you purchase or use has a cost. Mutual funds are the same. Several types of mutual funds are provided to us by Asset Management Companies (AMC) or Fund Houses, and each fund is managed by a professional. Managing the fund and its operational costs requires a lot of behind-the-scenes effort, which is expensive. The mutual fund expense ratio is the name given to this fee, which is distributed to investors as a proportion of the value of your investment.

What is the expense ratio in mutual funds?

The expense ratio is a percentage used to indicate how much you are paying over to the asset management company (AMC) to manage your investments. In other words, it represents the cost of operating and managing the mutual fund per unit. Expense ratios vary from every mutual fund to another. This cost ratio is determined as a percentage of the daily investment value; you do not pay for it separately.

Components of Expense Ratio

A mutual fund expenses ratio may include a variety of costs, including: 

Fund Management Fees: Every mutual fund has an investing goal, and the fund manager’s choices ensure that these goals are achieved. The fund manager’s salary is included in the expense ratio for these actively managed mutual funds. With passively managed funds, this component of the mutual fund expense ratio is significantly lower than with actively managed funds because the fund manager need not manage the fund’s portfolio actively in the former.

Legal/Audit Fees: Since mutual funds are supervised by the Securities and Exchange Board of India (SEBI), they must constantly seek legal advice and have their procedures, plans, and other operations audited in order to comply with all rules and laws. The spending ratio also includes any fees for audits, registration and transfers, legal checks, etc.

Marketing or distribution fee: The expense ratio includes the expenditures related to marketing and distribution of the mutual fund, as well as the costs of raising awareness of it and distributing it through mutual fund distributors. By investing in a regular fund, there are fees for brokers like the distributors, so the cost component for intermediaries is higher for regular funds and lower for direct funds. 

The brokerage fee is another name for this charge. As a result, investing in direct funds will be less expensive than investing in regular funds. The earlier marketing and leaflet distribution section is subject to the 12B-1 fee. The expenditures listed above collectively make up the mutual fund expense ratio.

Limit on Expense Ratio by SEBI

All (AMC) asset management company expenses must be handled within the parameters outlined in Regulation 52 of SEBI Mutual Fund Regulation^[1]. In accordance with these rules, the total expense ratio (TER) is permitted for the first Rs. 100 crores of average weekly total net assets at 2.5%, the following Rs. 300 crore at 2.25%, the next Rs. 300 crore at 2%, and the remaining asset under management (AUM) at 1.75%. The limit on debt funds is 2.25 per cent. Also, as a further incentive to expand into smaller towns, the Securities and Exchange Board of India permits all mutual funds to charge a 30 basis point additional (B15 Cities). Moreover, these cities receive an additional 20 basis points in exit load costs.

Calculation

For instance, if you put Rs. 50,000 in a fund with a 2% total expense ratio, the fund house will receive Rs. 1,000 in exchange for managing your money. If a fund earns 20% and has a 2% expense ratio, that equates to an investor receiving an 18% return.

Reason for the new proposal in expense ratio by SEBI

• Presently, the expense ratio, which accounts for the distributor’s commission, fund management fees, and marketing fees, among other fees, the commission that mutual funds charge varies by product. For scheme types like large-cap, flexi-cap, and mid-cap, among others, it varies within equities. The expense ratio is also influenced by a number of additional variables, including the fund’s size and style, because it is not a uniform expense ratio.

• Discovered that a significant portion of the money invested in equity New Fund Offerings (NFOs) in recent years pulled in from already-existing schemes. According to the source, the regulator believes that a number of mutual funds brokers and distributors pressured clients to transfer funds from their current investments to new ones in order to increase their commissions.

• Industry estimates indicate that approximately 20% of the total assets managed by the sector last year were invested in the more expensive equity NFOs.

• The trail cost paid by mutual funds to distributors for investments held for older equity money is roughly 0.25%, whereas the fee for recent NFOs was as high as 1.5%.” Distributors would have advised clients to book profits under the guise that NFOs offered better prospects and older schemes were struggling.

• The Cost ratio affects the commission that mutual fund distributors are paid. When the ratio in expense for mutual funds is higher, commissions typically increase. The expense percentage levied by mutual funds also applies to regular plans and includes commissions to distributors. According to Sebi’s structure, an equity programme may charge a maximum total expense ratio of 2.25%.

• Sebi last modified the expense ratio framework in September 2018. Assets under management in the mutual fund sector have since increased by approximately 65%, reaching 40 lakh crore on December 31, 2022.

• Since the regulator’s announcement in December that it had started a thorough investigation into the fees and expenditures incurred by mutual funds, rumours have circulated that Sebi may be trying to change the rules governing the overall spending ratio. The regulator stated that the study would aim to give information that can be used as “input for policy formulations.”

Conclusion

According to the regulator, there is still room to cut the total expense ratio of mutual funds for a uniform expense ratio. Now the mutual fund is making more money by accumulating more assets and making it a volume game. As per the current Sebi suggestion, if the expense ratio is equal for all equity plans, distributors would be prevented from pushing customers to switch to other products or schemes in order to receive a bigger commission, which would reduce mis selling. The regulator thinks there is still scope to lower the mutual fund’s total expense ratio to make it a uniform expense ratio more affordable to investors.

Also Read:
How to start a mutual fund company in India?
Mutual Funds – Different types of Mutual Funds in India