The Securities and Exchange Board of India (SEBI) is stepping down hard on mutual funds charging lower expenses under the same fund from bigger customers. Till now, mutual fund companies have operated separate plans for larger and smaller customers under many of their funds. This practice is most prevalent in shorter-term debt funds but exists in some equity funds also.
The plans intended for larger investors keep out smaller investors by setting higher investment limits. Typically, the minimum amount of investment in a retail (small investors’) plan is Rs 5,000 or Rs 10,000, while the entry amounts for institutional and super institutional plans are Rs 1 crore and Rs 10 crore respectively. The retail plans are likely to deduct around 0.75 per cent per annum from investors’ funds as expenses while the cheapest institutional plans charge just about 0.1 per cent.
To an equity investor, these numbers may not make much of a difference, but for those, who invest in debt funds, a 0.75 per cent expense fee could mean a lot. To show the real impact of the difference in expenses, I will translate the expense figures to a percentage of the returns generated by fund. Short-term debt funds typically generate returns of at most 5 per cent a year. That means a retail investor is paying around 15 per cent of his returns as expenses, while an institutional investor is parting with just 2-3 per cent of his returns as expenses. That’s not a small difference.
Having larger and smaller customers could easily create situations, where smaller customers are at a disadvantage. Since larger customers are more prone to shop around for lower expenses, fund companies may split expenses between retail and institutional plan in a manner that is disadvantageous to the former.
However, fund companies also have a valid point. It is genuinely cheaper to find and serve larger customers than it is to serve smaller ones. There is hardly a business in the world that will not give you cost advantage if you purchase its goods and services in bulk. It is a fundamental rule of all businesses that wholesale customers get things at cheaper prices. If serving large customers is cheaper then why shouldn’t those customers reap the benefits?
But SEBI’s new stance doesn’t actually prohibit this. The news stories and the analysis on this issue are all focused on SEBI enforcing identical pricing for large and smaller customers. However, as far as I can see, it has enforced identical pricing only within plans of the same fund scheme. The underlying principle here should really not be a socialist desire to sock the rich but to maintain the integrity of the ‘mutuality’ of a mutual fund. All the plans of a single fund scheme are a single pool of money. They are managed together and the expenses must be equally shared by all investors.
This equal sharing is where funds must live up to the word ‘mutual’.
However, the commercial principle of charging less from wholesale customers is just as valid. Clearly, the only solution is that if fund companies really need to charge less from wholesale customers then there should be distinct fund schemes that are run separately and are meant just for larger customers. This would isolate smaller customers from the ill-effects of being in the same fund as larger ones.
This article was originally published on July 21, 2010.
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