So what really is behind SEBI’s issue with expense ratios?
Foundation of Independent Financial Advisors of India (FIFA)
Incorrect perceptions, if not corrected in time, have a way of getting accepted as reality. And sometimes, such perceptions then become the cause for regulatory changes that have far reaching implications for everybody in the industry – especially the person standing at the bottom of the pyramid – the small IFA.
A perception was created that Indian mutual fund costs are among the highest in the world (courtesy Morningstar’s GFIE report, and their subsequent PR overdrive on Indian MFs being among the costliest in the world) – which became a focal point of media and regulatory attention some time ago, until FIFA produced its initial report that disproved this notion. FIFA followed this up recently with a comprehensive report that compares mutual fund expense ratios in India with other markets globally (Read the full report here), which clearly brings out the fact that cost of owning mutual funds in India is actually among the lowest in the world and not the highest.
But somehow, the perception that expense ratios are unduly high, persists. SEBI Chairman in his recent address to the industry in AMFI’s Summit, alluded to “high profits” of fund houses as one of the reasons to consider rationalizing expense ratios. SEBI, we hear, has constituted a committee to look into this aspect. Separately, we are informally being told that “exorbitant payouts” to large distributors – sometimes extending to 80% - 100% of distributable TER, is annoying the regulator, who believes that if such large commission payouts are being made by fund houses, they probably can do with less TER and pass on some of the savings to investors rather than to distributors.
Perceptions can be deceptive – it is important to stay in the realm of facts. In that context, I want to draw the industry’s attention to two aspects:
Are our expense ratios among the highest or the lowest in the world?
We felt compelled to undertake the exercise of compiling our report on comparing expense ratios in India vs other global markets as the Morningstar GFIE reports portrayed Indian mutual funds as among the most expensive in the world, while our independent study established that cost of owning mutual funds in India is actually among the lowest in the world. While we can go into several details of differences in methodology and assumptions that lead to opposite conclusions, I think the broad point is that any comparison must be made among comparable sets of data. You compare apples with oranges and you are bound to get inaccurate results.
Mutual funds in India and in several parts of the world are offered in bundled as well as unbundled options. Bundled is where the cost of intermediation and allied services is included in the product cost (which is our regular plans whose expense ratios include distributor commissions) while unbundled is where the investor pays the fund house its management fee (like our direct plans) and then pays separately for advice (fees to the RIA) and platform charges (wrap accounts that facilitate RIAs to recover their fees).
In Morningstar’s universe of 25 countries it tracks for its GFIE report, it states that 15 are predominantly commission based and 10 are largely fee based. Now, why would you club the expense ratio of an unbundled product (10 countries) with that of a bundled product (15 countries) to decide which one is cheaper? Wouldn’t it be more logical to put them into two separate tables and then compare within each table? For some reason, Morningstar is not doing so, which causes avoidably incorrect conclusions which in turn shape distorted opinions.
SEBI’s committee should commission an independent study
We have provided very detailed workings and have backed up our assumptions with logic, in arriving at our set of numbers. The conclusions from both reports are diametrically opposite. While we obviously stand by our findings, as an objective industry participant, I would say that the first task of SEBI’s committee that has been set up to review expense ratio structures, should be to commission an independent study – perhaps by a reputed consulting firm – which can independently come up with a logical framework of comparing cost of owning mutual funds in India vs other comparable markets which are at a similar stage of development and penetration of mutual funds. Facts are always better than perceptions to drive decisions – and a study commissioned under SEBI’s aegis will perhaps be treated as fact by the regulator rather than an opinion.
Profiteering and its logical solution
If SEBI’s thinking on reducing expense ratios is not being guided by international comparisons, but by a notion of excessive profits within the manufacturing and distribution businesses, which it believes ought to rightfully go to the investor, it is all the more important that we first distinguish between facts and perceptions.
If SEBI wants to see more competition in the AMC space, that can only happen when even the smaller firms are making profits that are healthy enough for them to reinvest in business expansion. Unless smaller firms are able to expand their reach, competition will suffer. An independent study should be made to determine whether profits in the fund industry are “excessive” in this context. Let facts speak for themselves – let us not get ahead of facts with our own perceptions.
Then comes the issue of large distributor payouts to attract inflows – which we are told sometimes amounts to a very sizeable proportion of distributable TER. Again, it would be instructive to get down to detail – where are the pockets of such “excessive” payouts, how many ARNs out of the total registered distributors are getting these “high proportions” of distributable TER as commissions? If it finally comes out that a small fraction of ARNs received these “high” payouts while 95% of active ARNs did not, how should you attempt to address this issue? By reducing expense ratios that will impact all or by other methods to rein in excesses where they actually exist?
White paper is the need of the hour
The discussions in media and among opinion makers are currently revolving around perceptions – either about how costly Indian funds are compared with the world or how much profits are being made – some of which should go to the investor. The international best practice that most evolved regulators adopt is to first define the problem statement and then consider solutions to that problem. The problem statement is typically put out in the form of a white paper by the regulator, who also puts out options under consideration to deal with the problem. This allows industry participants to engage meaningfully with the regulator on both aspects – the problem as defined as well as the options under consideration. This healthy dialogue often results in outcomes that are truly win-win for all stakeholders, with the investor always at the centre.
We find ourselves in a situation where we are discussing a potential solution – reduction of expense ratios – without first understanding what exactly is the problem statement. Is the problem that our costs are too high compared to global standards? Is the problem that super-normal profits are being made somewhere in the chain, at the expense of the investor? What is the problem we are seeking to solve?
We also hear about the possibility of re-introducing sub limits within TER for different types of expenses. This was expressly done away with when fungibility was given to the industry in 2013. So the question again is why talk about a solution until we are all clear what the problem is?
The only sensible way forward I believe, is for SEBI to put out a white paper on mutual fund costs, where it should define what the problem statement is and what are the options under its consideration. I believe SEBI should trust that such a move will result in healthy dialogue that can result in solutions that are in the best interests of investors – both existing and the many more who are yet to adopt mutual funds as their preferred investment vehicle.
Let facts guide regulatory decision making
Here are a few facts that I believe must guide regulatory decision making on expense ratios:
Fact # 1: Cost of owning mutual funds in India is among the lowest in the world – a fact that has been brought out clearly in FIFA’s report. Global comparison therefore does not suggest any need to bring expense ratios down
Fact # 2: For investors who want lower cost options, the regulator has anyway introduced direct plans, and unlike anywhere else in the world, has permitted even first time retail investors with no investing experience to go direct, without any protection of checking suitability of the product.
Fact # 3: If distribution margins are indeed very high (as seems to be the perception), why is it that the MF industry is still unable to attract young entrepreneurs into the distribution business? Talent goes to where the rewards are. The growth in new ARNs is disproportionately small to the growth of the industry. Clearly, lakhs of fresh graduates coming out of colleges across the country don’t see enough money in making a career out of distributing mutual funds.
Fact # 4: Concentration of assets among leading fund houses needs to be tested against concentration in other parts of financial services including life insurance and banking to determine whether it should be a cause for concern. As mentioned earlier, to make smaller fund houses more competitive, they need to be able to invest in expanding their reach. It needs to be reviewed whether their businesses – at the current expense ratios – are sufficiently profitable to enable them to make such investments.
Fact # 5: Any reduction in TER will only increase concentration and not decrease it. When you squeeze margins, only the big survive and the small fade away. This is true for any business and it will be the case in our industry as well – both at the fund house level as well as the distribution level.
Fact # 6: The perception around distributor commissions is entirely misguided since revenue is being confused with profits. From the gross revenue that a distributor earns, he pays out 18% as GST, then he pays his staff, he pays for his technology and office infrastructure that enables him and his team to serve his clients (unlike direct investors who get no service), then he pays income tax on profits and what is then left is his profit that pays for his and his family’s needs. In deciding whether to cut expense ratios, an impact analysis of such a move on the financials of small IFAs needs to be conducted to ascertain the advisability of any such move.
FIFA willing to extend all support for a white paper
We at FIFA will welcome a move from the regulator to publish a white paper on mutual fund costs and are willing to extend our whole-hearted support to such an objective exercise which can hopefully form the cornerstone of meaningful, progressive, investor and growth centric regulations.
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