Last week, I wrote about how shorter-term debt funds, which form a huge 53 per cent of the 8.05 lakh crore fund industry, are going to become somewhat more unstable in their returns than their investors are used to. And since almost all investors of these funds are corporate looking for a predictable place to park their temporary cash holdings, this could well change the business of such funds in unpredictable ways. This instability is the result of SEBI's new rules for valuing short-term debt holdings of mutual funds.
However, this particular change is not the only impending rule change that could increase the day-to-day volatility of such funds. SEBI has also proposed some changes in the way mutual funds charge their expenses, one of whose side-effects to further increase the day-to-day volatility of returns. Mutual funds charge a certain fee for running a fund. This is generally in the range of 0.2 to 0.7 per cent per annum for debt funds (with a regulatory limit of 1.75 per cent) and 1.5 to 2 per cent per annum for equity funds (with a regulatory limit of 2.25 per cent). However, in actual application, these fees are charged daily on a pro-rate basis. So a fund that charges 0.5 per cent of expenses per annum will actually be charging 0.00137 per cent per day.
However, there is no rule that says expenses must be charged at the same rate for every day of the year. Real expenses don't follow a smooth line. There could be unplanned changes in actual expenditure. Also, as a fund grows or shrinks, expenses that are actually fixed in rupee terms could end up being a larger or smaller percentage of the assets being managed. Therefore, fund companies are legally at complete liberty to charge whatever they like on a daily basis as long as the annual limits are adhered to.
For debt funds, expenses end up having a significant impact on the relative performance of debt funds and fund companies use the expense level to manage the expense level. It's important to understand what I mean when I say that expenses have 'a significant impact on the relative performance of debt funds'. The spread of returns in debt funds, specially the big shorter-term fund categories is very narrow. A small difference in returns can significantly change the ranking (and thus the saleability) of a fund. For example, among institutional Ultra-Short Term funds, one-year returns of about 20 of the 49 funds is stacked in a range of 0.4 per cent. To take one specific comparison of the interplay, the number 2 fund is ICICI Prudential Liquid Super Institutional with 4.6 per cent returns and number 19 is Tata Liquid Super HI with 4.32 per cent, a difference of just 0.28 per cent.
Since the total expense charged is a sum of the actual expenses as well as the discretionary management fee that the fund company charges, there is reasonable room for manoeuvre in terms of actual expenses charged. Clearly, how much and when a fund company decides to charge expenses can have a significant difference on a fund's returns. What SEBI has found out is that there is considerable day-to-day variation in the expenses fund companies charge within overall limits. One reason for doing this could be to smoothen out returns-on days that the fund has not done well, it could be charged lower expenses. Another could possibly be to favour certain large investor as they move in or out of funds. Either way, SEBI thinks that this kind of expense management is not appropriate and would like funds to stick tovariation within a certain pre-defined range. Either way, the manoeuvrability of funds companies gets reduced, and the shorter-term funds become a little more volatile.
This article was originally published on June 11, 2010.
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