Revealed: the shocking truth about mutual fund expenses

Date : 23/06/2023
Read: 3 mins

SEBI considers performance-based management fees for mutual funds to address underperformance concerns and improve investor outcomes.

SEBI is analysing the underperformance of actively managed mutual fund schemes and considering performance-based management fees.
More than 22% of regular mutual fund plans have underperformed benchmarks by over 1.25%.
The proposed model suggests higher management fees for schemes that exceed a pre-determined benchmark.
SEBI has proposed two approaches for implementing the performance-linked expense ratio.

Mutual funds have long been a popular investment option for individuals looking to grow their wealth. However, recent underperformance of various actively managed mutual fund schemes has raised concerns among investors and regulatory bodies alike. In response to this, the Securities and Exchange Board of India (SEBI) is considering a performance-linked management fee for mutual funds.

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SEBI’s MF performance analysis

Currently, fund houses charge management fees and expenses regardless of the scheme's performance. However, SEBI's analysis of the performance data of active mutual fund schemes reveals a significant underperformance of regular plans compared to direct plans. More than 22% of regular plans have underperformed the benchmarks by more than 1.25% over various time periods.

SEBI acknowledges that certain factors and constraints applicable to mutual fund schemes, such as investment limits and scheme expenses, can contribute to this underperformance.

Performance-based expense ratio

To address this issue, SEBI is exploring the concept of a variable expense ratio based on the performance of the schemes. Under the proposed model, fund houses may charge higher management fees if the scheme's performance exceeds a pre-determined benchmark. This can be either based on an indicative return above the tracking difference adjusted benchmark or a pre-decided hurdle rate. Higher management fees can be fixed or based on a returns-sharing basis.

Solutions proposed by SEBI

SEBI has proposed two approaches for implementing the performance-linked expense ratio:

First approach: Base expense ratio charged regularly, fees deducted at redemption for returns surpassing the indicative rate or hurdle.
Second approach: TER (Total Expense Ratio), including management fees, charged throughout investment tenure; if returns fall below the pre-determined rate at redemption, only base TER is charged, rest is refunded.

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What are the risks involved?

While SEBI expects this move to align the interests of fund managers with investors and improve fund performance, there are potential downsides to consider. Fund managers may be tempted to take excessive risks to generate better returns, focusing on short-term gains at the expense of long-term growth. Moreover, investors may face challenges in comparing different expense ratio options when choosing mutual fund plans.

SEBI recognises the need for careful evaluation and testing of the performance-linked expense ratio model before implementing it widely. The proposal will be tested in a regulatory sandbox environment to assess its effectiveness and impact on mutual fund investors.

While the introduction of a performance-linked expense ratio for mutual funds holds the potential to boost performance, the associated risks and challenges must be carefully evaluated. To ensure fair value for expenses incurred, investors need to stay alert and evaluate the expense ratios of their mutual fund investments diligently.