The Securities and Exchange Board of India (Sebi) announced a proposal on 28 October requiring mutual funds to charge a performance-based expense ratio in a scheme, along with other measures to revamp regulations in the sector.
Some fund houses have individually submitted feedback to Sebi on the complexities of charging a performance fee, six people aware of the matter told Mint. A discussion on the matter at the Association of Mutual Funds in India level is yet to happen, three of them said.
The key concern for asset management companies (AMCs) is the complexity of calculating a performance-linked expense ratio of a product where investors enter and exit at different points. Two investors in the same scheme can experience very different returns, depending on when they invest, making it difficult to arrive at a single performance-based fee that applies fairly to all.
This uncertainty could leave fund houses unable to estimate revenue, while investors may struggle to anticipate how much they will end up paying, particularly in a volatile market.
“Mutual fund investors will not be able to easily estimate in advance what the fee will be as it includes a complex accounting mechanism,” said Deepak Shenoy, chief executive officer at Capitalmind Mutual Fund, adding that there is an operational complexity with implementing performance-based expense ratios.
Such an expense ratio for performance would be voluntary and a detailed framework would be finalized separately in consultation with stakeholders, according to the draft Sebi paper.
“In the event of a sharp market downturn, mutual funds may struggle to even cover management costs as the performance-based fees may not be earned,” said Jimmy Patel, managing director of Quantum Mutual Fund.
Clear benchmarks
Patel added that for such a model to work, AMCs would need robust investment processes, sufficient portfolio liquidity and clear benchmarks as monitoring performance for investors at large would ultimately depend on the ability to consistently generate alpha over the benchmark.
Fund houses are also uncertain about how the performance of a scheme would be established to qualify for rendering a fee.
“It’s not easy to define performance in capital markets. Should the performance be judged on the basis of one year, three years or five years? Should one judge performance on the basis of rolling returns or point-to-point returns? These are difficult questions. And until these things are clearly defined, there will be no visibility of further regulations on performance fees,” said an AMC official on condition of anonymity.
However, the market regulator wants to implement the proposal for the benefit of investors.
“Sebi is keen on introducing a performance-based expense ratio like the one prevalent in PMS (portfolio management services) as it would help investors differentiate between different schemes and funds,” said a person privy to the regulator’s discussions on the matter. “Right now, all mutual funds are coming out with similar schemes and structures – there is no differentiator. Sebi wants AMCs to come up with a framework that would work well for them. The idea is to set a benchmark above which performance fees can be charged, similar to PMS.”
The concept of performance fees is not new. Alternative investment funds (AIFs), which are pooled funds similar to mutual funds with a higher entry point, and non-pooled structures such as PMS already offer a fixed fee, a performance fee or a mix of both to clients.
AIF fee models
In an AIF, investors can choose between fixed fees and performance fees. Under the fixed-fee model, the investor pays a flat annual fee, calculated as a percentage of the fund’s assets, regardless of how the fund performs. Under the performance-fee model, the fund manager sets a hurdle rate. Performance fees are charged only on returns earned above this hurdle and these excess returns are shared between the investor and the fund manager.
Assume that an investor enters an AIF at a net asset value of ₹100. After 12 months, the NAV rises to ₹130, which is a return of 30%. If the hurdle rate is 12% for the year, performance fees apply only to the additional 18% return earned.
The profit-sharing arrangement is mostly 20:80 – the fund manager gets 20% of the 18% outperformance, while the remaining 80% goes to the investor as returns. To be clear, the investor gets the invested amount net of the fees.
Such a framework is difficult to implement in mutual funds because the number of investors in a mutual fund exceeds the number in an AIF by a huge margin.
“In open-ended AIFs, investors enter and exit on specific valuation dates—monthly, quarterly or mid-month, where the NAVs are calculated,” said Pramod Gubbi, co-founder of Marcellus Investment Managers, which runs an AIF, among other investment products. “Mutual funds are different because investors enter and exit daily and fairly attributing performance to investors entering and exiting on different dates can be complex.”
Technology can solve this and compared to what AI handles today, this level of computation should not be a major challenge, Gubbi added.
Emailed queries to Sebi and AMFI did not elicit responses.