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An Incentive System for Funds

Instead of handing out a straight hike in expenses, SEBI has crafted an astute incentive system for mutual funds

The boss hasn’t really increased any one's salary, but has instead created a clever incentive system that will enable higher income for those who are able to work towards furthering the larger goals of the business. I’m talking not about any company’s performance appraisal but rather about what SEBI chairman U.K. Sinha has handed out, metaphorically speaking, to the mutual fund industry.

Last Thursday, markets and funds regulator SEBI unleashed the biggest structural reforms in mutual funds since the July 2009 abolition of entry loads. In some ways, the current changes are an attempt to rejuvenate the mutual fund industry from some of the depressive affects of the entry load abolition. The last three years have seen a combination of poor returns and reduced effort by mutual fund distributors, which has resulted in poor inflows into mutual funds, specially retail inflows into equity funds.

However, what the regulator has pulled out of its hat is not a straightforward increase in chargeable fees that the industry was hoping for but a clever, well-structured incentive system that will mean higher profits for those AMCs which can succeed in the larger national goal of expanding the retail reach of mutual funds beyond the big cities where it’s currently concentrated.

From now on, getting fresh investments from outside the 15 largest cities will earn AMCs an extra percentage of the entire asset base that they have. They can charge up to 0.3 per cent extra expenses on the entire assets if they get 30 per cent of assets outside the top 15 cities. Lower percentages will mean a correspondingly smaller extra expense chargeable.

SEBI’s formula for this incentivisation sounds complex but the end result is quite simple. It means that effectively, AMCs stand to annually earn an amount that is 1 per cent of whatever they collect from the smaller cities from here onwards. So if a fund gets Rs 100 crore from the smaller places, it will get to charge an additional Rs 1 crore from the assets its managing. This is a substantial sweetener and one can expect that sooner rather than later, mutual funds will get serious about expanding their reach. SEBI has made geographical expansion the key to earning the extra that funds need to expand both in big cities and small. Effectively, this is the only way for a fund company to improve the economics of its business from now on. It’s much better to have an incentive system than to issue a fiat.
SEBI has also brought in a whole host of other changes. The most impactful will probably be the one which makes the entire expense charged by funds fungible, i.e., it can be treated as a single pool which the AMCs can divide between expenses, fees and profits as they deem fit. Till now, there was an internal division in the expenses charged between actual expenses and management fees.

SEBI has also decreed that exit loads paid by investors should be ploughed back into the fund itself, meaning that it will add to investors’ NAV. However, 0.2 per cent of the exit load will actually accrue to the AMC, or ‘clawed back’, to use SEBI’s term. And from now on, service tax on the part of the expenses that are taxable, will be paid by the investor. So far, this has been paid by the AMC. SEBI’s logic is that in all other industries, the customer pays service tax. This is correct but still amounts to an increased outgo.

All in all, investors could see a 0.1 to 0.4 per cent increase in the fee that they effectively pay to have their funds managed. Any increase ends up reducing the returns that funds generate but all in all, this has been a deftly managed round of reforms that could get a decent bang for the buck.