Letter to Finance Minister on Impact of SEBI's new regulation for Mutual Funds

SMALL INVESTOR’S FORUM

( Initiave of Pune Investor Grievances Forum (Regd))

PETITION/LETTER TO FINANCE MINISTER/SEBI

Dear Sir,

Sub: Impact of SEBI’s new Mutual Fund Regulations on the Small Investor.

On the 16^th of August, SEBI has come out with a Press Release announcing changes in Mutual Fund Regulations.

Currently, it is a press release which means we only get the outline of the changes proposed. Soon, this will be followed by a circular (more than one, likely) which will contain more details. The circular(s) will be analysed by the mutual fund compliance officers (and probably, AMFI) and they will come out with guidelines of implementations which is when we will really know the true import of the changes.

The SEBI’s Note starts with “Steps to Re-energise Mutual Fund Industry”. It states that SEBI took note of the lack of penetration of Mutual Fund Products, inadequate distribution network, need for greater alignment of the interest of various stake holders, regulation of distributors and issues concerning investor protection, and has approved some immediate steps, which are:

·        Increase in penetration of mutual fund products and energising distribution network,

·        Improve reach of MF products beyond the Top 15 cities,

·        Alignment of interest of investors, distributors and AMC’s

·        Investor protection – issues of mis-selling and churning

·        Strengthening regulatory framework for Mutual Funds

·        Long term measures

·        Rajiv Gandhi Equity Savings Scheme

As per the SEBI press release, Mutual fund space has got fungibility with regards to expense ratio. Now the AMC can pretty much decide under what head it wants to spend, how much. The exit load will now be credited back to this scheme and this is really to curtail the high churning that goes on in each of these schemes.

Another important change is 30% of the incremental sales come from beyond the top 15 cities, the expense ratio can be increased by 30 basis points and this will be proportionate to the incremental sale. The service tax will now be charged ultimately to the investor which is at the rate of 12.5% which is currently borne by the AMCs.

Sebi will also set up a self regulatory organisation to regulate selling of mutual funds. It has also asked mutual fund advisory committee to come out with a national mutual fund policy that will deliberate on the tax issues and the disclosures obligations which it has placed on the asset management companies.

It has also recommended to the government tax benefits to equity MF investors under the proposed Rajiv Gandhi EquitySavings Scheme (RGESS).

However, it would be a mistake to imagine that these steps will actually, by themselves, re-energise retail investment in mutual funds and capital markets. These are no more than enablers—important and crucial, no doubt—but in the final reckoning they are part of the supporting cast.

Investments will get re-energised when savers feel that they’ll get good returns, get drawn to investments and enthusiastically put their money into equity-backed investments.

In mutual funds, the thrust of the changes is to set up an incentive system that will allow asset management companies to charge higher expenses if they succeed in making inroads outside the larger cities where fund investors are currently concentrated in. The new rules also incorporate a series of other changes that collectively improve funds’ economics while imposing a somewhat higher cost on investors.

There are three or four items in the press release that warrant closer look in this regard:

Firstly, higher expense ratio for promoting MFs in Tier II cities – SEBI has proposed that an MF can charge up to 30 Basis points (bps),  (one bps is one hundredth of a percent, so 30 bps is 0.30%) more in its total expense ratio towards promoting mutual funds in places outside of the top 15 cities.

However, this raise is tied to the goal of getting 30% of the new inflows from these places.  If an AMC gets less inflow, they will be allowed to charge only up to the % of inflows they get – that is, if 5% of new inflows to a scheme are from these places, then the expense ratio will go up by 5 bps only.

Currently, the inflows from these Tier II or lower places are negligible. Bringing them up to 30% is a huge task and it is very likely that for the first few years at least, this increase will be in the 5 to 10 bps range at best.

The permission to charge an additional 30 basis points (bps) as total expense ratio (TER) on sales beyond the top 15 cities may look attractive, but mutual fund industry executives have taken it with a pinch of salt.

Barring a few top fund houses, most others do not enjoy widespread presence outside the top 10 cities. Moreover, according to the latest statistics, close to three-fourths of the overall industry’s assets pour in from the top five cities—Mumbai, Delhi, Bangalore, Kolkata and Chennai. And after including the next top 10 cities, the industry gets a whopping 87 per cent of its assets

We fail to understand this regulation – asking the top tier cities’ investors to directly bear the cost of getting tier-II cities’ investors into the big tent of mutual fund investing.

Second issue is regarding the ‘service tax’.

SEBI has announced that service tax that has so far been borne by the AMCs can now be passed through to the investors.

In all other industries anybody who has received an invoice for a service is familiar with the “Service tax extra” remark in addition to the quoted amount.

AMCs provide a service (fund management service) to investors and can now rightfully start charging the investors the requisite amount. This charge, however, is apparently likely to be 2-3 bps (according to the press release).

We feel that this 2-3 bps is more likely to increase the overall impact across schemes. For equity schemes, it is likely to be higher, more in the 7-8 bps range for big funds and 10-12 bps range for smaller funds (service tax is charged on the amount that an AMC gets to keep from the expense ratio, so it will differ from AMC to AMC and scheme to scheme).

The service tax impact will also be affected by the new “fungibility” clause which allows AMCs to be unfettered with regards to how it wants to manage the expense ratio. The amount that will be subject to service tax will depend on how much the AMCs choose to charge from the expense ratio.

The third item is the clause about exit loads. However, this is likely to be a zero sum game between the AMC and the investor. The press release states that the exit load charged to premature exit investors will now need to be credited back to the scheme account (and not the AMC account),  and an equivalent amount (up to a limit of 20 bps) can be added to the total expense ratio to compensate for the loss to the AMC account. What this means is that the credit of exit load to the scheme account will be balanced by the expense ratio. So neither the AMC nor the investor stands to gain.

There is another angle and that is the distributor. Thus far, the distributor  was getting paid by the AMC in the form of upfront commissions by the AMC from the exit loads. Since that money will now come distributed across time in the form of expense ratio, this commission will now go away and probably be replaced by a slight bump in the trail commission.

This move is to discourage “churning” by distributors to earn upfront commissions.

SEBI’s attempt to curb churning in this manner is confusing. The release states, “The entire exit loads would be credited to the scheme while the AMCs will be able to charge an additional TER to extent of 20 bps. This will not result in any additional cost to the investors”, which means that the upfront commission that was being paid out from the exit load would stop as the entire amount would be added back to the fund. The AMCs would be compensated with a higher TER of up to 20 bps. But what if the amount generated through TER is greater than the amount generated through exit load; this would then be an additional cost to the investors.

The real impact on the investors at least in the initial years is likely to be between 10-15 bps bump in the expense ratio.  It will be determined by two factors – what the service tax is computed on and how successful AMCs are in achieving their social target of MF penetration.

The relaxation in the requirement for PAN card for applying for mutual funds, appears to be a cosmetic move. It is unlikely to result in hordes of farmers queuing up to purchase units by paying in cash. But more pertinent, there is no clarity on how the redemption proceeds will be processed. It is highly unlikely that it will be in cash. This may be a bigger impediment than the PAN Card for such prospective investors.

Mis-selling and churning are widespread evils. However, as in the case of insider trading, it is difficult to pin down offenders who mis-sell. Usually, agents make clients sign on undertakings that they have understood the features and are cognisance of the various risks involved. If at all, push-comes-to-shove, agents could always hold up that document as evidence that they were in compliance.

The additional 20 basis points towards penalty for early redemptions may not really deter inveterate traders, as the figure is fairly insignificant. However, it is a non-event for investors who remain invested.

To sum it upt, SEBI’s proposed changes to mutual fund regulations are oriented to enrich AMCs while small investors, who have lost money on several funds even after holding them for years, have been   brushed aside.

We request you to look in the matter urgently and grant us an appointment to present the views and expectation of the Small and Retail Investor.

Regards,

For Small Investors Forum,

Yogesh Kulkarni                     Dayanand Nene

                      CONVENERS