MFs modify expense structure for direct plans to improve transparency

Fund houses have cut, raised expenses for direct plans; move may lead to higher returns

A month after the Securities and Exchange Board of India (Sebi) came up with guidelines for greater transparency in the way expenses are calculated, fund houses have both cut and raised expenses for their direct plans.

By and large, expenses have reduced, which is a positive for investors as that may boost returns. Motilal Oswal Mutual Funds (MF) and Edelweiss MF have seen the expenses for their direct equity schemes drop by 20-30 basis points (bps). HDFC MF and Franklin Templeton MF, on the other hand, have raised the expenses of their direct plans by 2-10 bps. 

“The rationale for doing so (reducing expenses) is to align with the Sebi circular on the pricing of regular and direct plans. We are committed to fair pricing in our regular and direct plans, and also compensating distribution partners fairly and this move reflects that,” said Radhika Gupta, chief executive officer, Edelweiss Mutual Fund. “This is a positive for direct investors because these funds will now cost lower.”

An official of a large fund house attributed the hike in direct expenses to reduction in distribution commission, after the regulator cut the “additional expense” charged by MFs from 20 bps to 5 bps. 

According to experts, the realignment in expenses has more to do with how the fund houses were managing their distribution incentives. A steep reduction in expenses could mean the savings on commissions were not fully passed on to direct investors earlier. According to Sebi’s 2012 circular, direct plans were meant to exclude distribution expenses and no commission was to be paid from such plans. In practice, different fund houses calculated the expenses differently. 

Let’s assume the total expense ratio (TER) for managing an equity scheme was 200 bps and the distribution payout was 100 bps. 

In this case, the TER for direct plans should have been about 100 bps. If fund houses charged higher than 100 bps, it meant that the difference was either pocketed by the fund house or used to fund distributor activities such as junkets, which have now been curbed by the regulator. Direct TERs lower than 100 bps probably meant the direct plans were subsidised by the regular plans as fund houses wanted to attract more direct money. 

According to Amol Joshi, a Mumbai-based financial planner, the regulator has closed the loophole on the fungibility in investment management charges and has made it clear that the difference in direct and regular plans can only be equal only to the distribution payout incentives or expenses. 

“If the TERs of direct plans have gone up meaningfully, it means direct plans were subsidised earlier. If the TERs have reduced, it means direct investors were overcharged and with last circular the same is getting corrected,” said Joshi.

According to Sebi’s recent circular, fees and expenses charged in a direct plan (in percentage terms) under various heads, including the investment and advisory fee, shall not exceed the fees and expenses charged under such heads in a regular plan. It has prohibited the practice of passbacks to investors and reward or non-cash incentives to distributors.

Sebi, in its board meeting agenda note, had highlighted there was a tendency to charge the maximum permissible base TER for equity schemes but stay below regulatory limits for debt schemes. The investors in equity schemes are predominantly retail while those in debt are largely corporates.

Experts believe the expense ratios for both direct and regular plans are likely to change again after the final notification on the TER comes into effect. The regulator has capped the TER for fund houses with equity assets of up to Rs 500 billion at 1.05 per cent against 1.75 per cent earlier. The TER for lower assets has also been slashed, slab-wise. That for closed-end equity-oriented schemes is capped at 1.25 per cent.

New Look

• Several fund houses are cutting expense ratios for direct plans
• Few like HDFC MF, Franklin MF have raised expenses for these plans
• Earlier, direct plans with lower expenses were subsidised by regular plans 
• Funds that charged higher expenses used it to reward distributors 
• As per new norms, fee and expenses charged in direct plans cannot exceed those charged in regular ones
• Direct plans allow investors to bypass distributors and save on commission
• These have a higher net asset value than regular plans as the expense ratio is lower 
• Investors can save 70-100 bps in direct equity plans versus regular ones