Over the last few years, the expenses that mutual funds charge from investors for managing their money have increased to a point that they are now a serious drag on the returns that investors are getting. A variety of regulatory changes have meant that there are equity funds that cost investors up to and even more than 3 per cent per annum of the worth of their investments every year.
Till 2012, this number was capped at a total of 2.25 per cent. Within the 2.25 per cent, there was an internal limit of 1.25 per cent for management fees and the rest was for actual expenses. If actual expenses were lower, then funds stayed well under the 2.25 per cent limit. Later, acceding to demands from the fund industry, SEBI clubbed the two in a single limit of 2.25 per cent.
However, there were other changes too which hiked up the amount that is deducted from investors' assets. For one, service tax used to be charged only on management fee and that too had to come from within the limit. However, when the entire expenses in a single pool, service tax became chargeable on the entire amount. From this year, commission paid to distributors has also been brought into the service tax net but that's a separate story.
Over and above these, there is yet another expense head. Back in 2012, SEBI instituted an incentive system for mutual funds to encourage them to find more investors in smaller cities. This was done because funds have by and large remained a big city product, more so than many other financial products. The incentivisation system allowed funds to charge more expenses on their funds based on a targets of how much they were able to raise from smaller cities. For example, if 30 per cent of the fresh inflows of a mutual fund were from cities outside the top 15, then the fund could charge an extra 0.3 per cent expenses on its entire corpus. Lower targets are also there, which are 25 per cent for 0.25 per cent, 20 per cent for 0.2 per cent and so on.
At that time, with the fund industry facing a years-long slump and little incentive to broaden its reach, this system may not have been a bad idea. However, things have changed now, and the incentive system has become a serious load on investors' pockets. Large AMCs with multi-thousand crore funds can easily charge huge amounts of extra money by putting in a bit of effort on smaller cities. Its time for SEBI to re-examine just how much extra money are investors paying and what is being achieved in exchange.
To investors, with the equity markets doing well, the difference between a 2 per cent deduction and a 3 per cent deduction may not even be noticeable. However, accumulated over a long period, they are paying a big chunk of their returns as fees. Remember, expenses may be stated as a percentage of total assets, but what matters to investors is their size relative to returns. Take the example of an equity fund that generates average pre-expenses returns of 15 per cent per annum over ten years. Over the decade, if its expense were 2 per cent instead of 3, investors would earn 12 per cent more.
And even two per cent is not exactly low. The cheapest actively managed Indian equity fund, Quantum Long Term Equity Fund, charges 1.25 per cent. Compared to that, a 3 per cent expense means 20 per cent lower returns. And passively managed (index or ETF funds) are even cheaper, with plenty of them charging just about 0.5 per cent, compared to which the 3-percenters eat up 27 per cent of returns over a decade. By the way, for comparison, the bellwether S&P 500 ETF fund from Vanguard, the world's lowest cost fund manager, charges just 0.05 per cent!
It's pretty clear that because a variety of reasons, the money that Indian mutual fund investors are paying for fund management has crept up to uncomfortably high levels. It's time for SEBI to a good hard look at how much investors are paying for mutual funds' services.