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Higher Expenses Must Not Become Money for Nothing

Under SEBI's new rules, investors will have to pay more for fund investments but the fund industry must keep its end of the bargain

The latest round of mutual fund reforms that SEBI has announced have generally been welcomed in the media and investment analysts. The new rules could re-vitalise the mutual fund industry and create an incentive for fund management outfits to expand to smaller cities and towns. However, there’s no doubt that the price of all this activity will have to be paid by investors. Funds are going to be more expensive than they used to be by a margin ranging from 0.1% a year to 0.3% a year. Apart from this, investors will also have to bear service tax on at least some part of the expenses that are charged from them. This is undoubtedly a negative. It hardly needs be pointed out that higher expenses are never a good thing for investors.

However, I have no hesitation in saying that on balance, the current round of reforms are a positive force and the higher expenses are a justifiable side-effect of achieving some desirable outcomes. The main point here is that higher expenses are contingent upon fund management companies successfully expanding their reach to a greater proportion of the country’s population. It does mean that if a fund so expands its reach, then its existing investors will have to pay some of the cost of expansion to smaller cities. On the face of it, this looks like a sort of a subsidy charged to investors from larger cities.

This is not different from similar cross-contributions in other areas. For instance, banks’ agricultural and other priority sector business is subsidised by more affluent customers. In life insurance, longer-lived customers implicitly pay for less healthy ones. There are many more examples like this. No financial service, probably no business, runs on the basis of charging from each customer precisely what that particular customer costs.

Having said that, there is now greater responsibility on SEBI for ensuring that fund companies live up to the task that they are charged with. The better economics of the business must contribute to a genuine broad-basing of the business. This will mean that AMCs, specially the larger one, will have to spend more on business development in the real sense of the word; and SEBI will have to make sure that they do.

Another way in which costs can be kept under control and that is by making sure that SEBI’s new direct plan initiative meets with a broad response from funds. The idea is that AMCs should launch separate plans under various funds which can only be bought directly by investors without going through distributors. Since distributions costs get greatly reduced, these plans should have lower expenses. They will thus have a different (higher) NAV than the distributor-sold plans and thus higher returns.

According to what SEBI has said so far, it appears that the AMCs are under no obligation to launch direct plans for every single fund. On the other hand, it’s very likely that AMCs will be under pressure from distributors, especially large and powerful ones like banks to not launch direct plans. This is something that the regulator and even the media will have to guard against. AMCs must launch direct plans for their equity and hybrid funds and the expense levels of these funds must genuinely reflect the absence of distributor remuneration.

SEBI’s new set of regulations begin a new phase for Indian mutual fund investors as well as the industry. The regulator has made clear its intentions of treating higher expenses as an incentive to create a new kind of fund industry, which will ultimately benefit the investor. As in all new regulations, there will be weak points that no one could have visualised beforehand. However, it would be good if all stakeholders can appreciate the underlying spirit of the changes and work towards genuinely expanding funds. It would conversely be very bad if the usual suspects set about to figure out loopholes and ways to game the system.