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The mutual fund industry is going through another phase of upheavals and the latest was triggered by market regulator Sebi’s attempt to bring in transparency in mutual fund expense ratios.
Two factors forced Sebi to crack the whip.
First, the asset management companies’ (AMC’s) practice of using money collected from direct plans to pay commission to distributors.
How they can do it, you may ask, especially since the distribution commission can’t be charged to direct plans.
AMCs used to do this in a roundabout way through AMC fees.
For example, fund houses charge high AMC fees on both these plans and use a part of the fees collected from direct plans to pay distributors.
Since these fees are treated as AMC income and additional distributor payments (i.e.
over and above charged to regular plans) are treated as AMC expenses, an age-old practice that was never questioned.
Second, was the recent action of several AMCs of increasing the direct plan expense ratio after Sebi reduced the expense ratio cap of mutual funds.
While the intention of Sebi was to bring down the expense ratio, it resulted in expense ratio going up for a section of direct plan investors.
This is because in several cases, AMCs were charging the maximum possible expense ratio on regular plans and therefore, they had no option but to cut expense ratio for regular plans.
Since the expense ratio was much less compared to maximum cap on direct plans, AMCs decided to increase expense ratio on them.
In other words, compensate losses suffered because of the reduction in regular plan expense ratio.
This action infuriated Sebi and the regulator cracked the whip now.
Though charging direct plans through AMC route was perfectly legal, this was against the spirit of Sebi’s direct plan rules.
Sebi now told AMCs to charge distributor commission only on regular plans and not to direct plans indirectly.
In other words, the expense ratio difference between regular plan and direct plan need to be the distribution commission.
Let me explain this with the help of an equity mutual fund scheme charging 2% on regular plans and 1% on direct plans and used to pay 1.5% to the distributor.
For simplicity, we will assume that the AUM is equal for direct and regular plans.
Now this 1.5% distribution commission needs to come from the regular plan only.
What are the options available to AMCs First, AMC can increase the expense ratio of regular plan
(i.e.
its expense ratio will go up to 2.5% in this case).
AMCs did this for some schemes, where the regular plan expense ratios were well below the regulatory cap.
The next option was to reduce distributor commission to the existing gap.
However, this option is a risky one because there will be distributor backlash.
The third option was to cut the expense ratio of direct plans (from 1% to 0.5% in the above example) and keep on paying the distributor the same commission (i.e.
1.5%).
Though this will not impact distributors or investors now, this will put additional burden on the balance sheet of AMCs.
Will AMCs take a hit like this indefinitely
AMCs may cut the distribution commission later (i.e.
if distribution commission comes down from 1.5% to 1% in the above example, this may result in direct plan expense ratio going back to 1%).
To negate this impact from some schemes and to protect their profits, AMCs may also increase expense ratio of other schemes
(i.e.
both regular and direct plans).
Some AMCs have already started it.
So there is no purpose in jumping to direct plans looking at their very low expense ratio now, especially at actively managed equity funds where the expense ratio is less than 50 bps.
This is because the chance of AMCs increasing expense ratio later is high.
In other words, the best strategy for investors now is to wait and watch till things settle.
How much time would it take for the situation to settle The situation is still fluid and therefore it may not be easy to guess the exact time frame.
However, it is reasonable to assume that this may take at least three months.
