Is it time for performance linked expense ratios in mutual funds?

With so many mutual funds failing to beat the benchmark over the last 3,5,7 years, it is time for SEBI to come up with performance-linked expense ratios. A discussion.

Published: December 2, 2019 at 1:45 pm

Last Updated on December 2, 2019 at 1:45 pm

Many investors incorrectly believe active mutual funds (esp. large cap oriented ones) will have a tough time beating the benchmark on an absolute or even risk-adjusted basis in future.  The truth is, as we have repeatedly reported here (see links below), they were always having a tough time years before the SEBI rules came into play! So a natural question to ask is, why should I pay extra to run an active fund when it is not performing as it is supposed to. In this article, we discuss the need for a performance-linked expense in mutual funds.

The simplest and most-efficient option for investors is to switch to index funds. In fact, they can create a large cap, large and midcap and even mid-cap like portfolios by  Combining Nifty and Nifty Next 50 index funds. This article is not what an investor should do. This is clear. This article is about what the regulator should do to police active funds as they are not going away anytime soon.

First, let us consider the proof that active funds always found the going tough.

  1. This will change the way you invest: S&P Index Versus Active Funds report. Avinash Luthria discusses the April 2010 S&P Index Versus Active Funds report which said that Indian mutual funds, as a whole, do not beat the index. That first SPIVA report covered the five years from year-end 2004 till year-end 2009 and it said that 71% of Large Cap Active Equity Mutual Funds failed to beat the relevant stock market index.
  2. Only Five Large Cap funds have comfortably beat Nifty 100!
  3. Why we badly need a Midcap & Smallcap Index Fund: Performance Comparison with Nifty Midcap 100 & Nifty Next 50 Yes, we have now made a step in the right direction with Motilal Oswal Nifty Midcap 150 Index Fund (Should you invest?) and Motilal Oswal Nifty Smallcap 250 Index Fund (Will this make a difference?)

Have a look at how HDFC Top 100 Fund has performed over the last five years. The expense ratios shown are for the regular plan. Source: Value Research.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
Fund1-Year Ret3-Year Ret5-Year RetExpense Ratio (%)
HDFC Top 100 Fund9.6611.867.11.73
HDFC Index Fund – Sensex Plan13.4616.118.310.3
HDFC Index Fund Nifty 50 Plan11.8314.597.960.3

There is simply no justification for the extra  (1) management fee and (2) distributor commissions, but we will leave the commissions out of the discussion as one can (and should) opt for direct plans.

The results are similar for Quantum Long Term Equity too.

Fund1-Year Ret3-Year Ret5-Year Ret
Quantum Long Term Equity Value Fund-
S&P BSE Sensex TRI14.0116.678.7

Or ICICI Value Discovery

Fund1-Year Ret3-Year Ret5-Year Ret
ICICI Prudential Value Discovery Fund1.565.496.01
S&P BSE 500 TRI9.16138.62

This is simply too long a time for an active fund go without beating the index but not reducing expenses (in fact, often increasing it!). There are enough instances of such underperformance to indicate that the time has come for SEBI to impose performance-linked expense ratios.

How performance-linked expense ratios can be implemented?

Naturally, this is not going to be easy, but in principle is quite possible. The first step is to stop random expenses ratio changes as explained here: Why SEBI should stop frequent mutual fund expense ratio changes. The actual implementation can be done in two ways.

Method 1:

Suppose the upper limit of the management fee is 1%. If at the start of a financial year  (FY) a fund has failed to beat the index on an absolute basis (no fancy alpha, beta) for the last three years, the management fee reduces to say, 0.7% for that FY

It can only go back up to 1% (but no further) if it can demonstrate absolute outperformance over the last 3Y at the start of future financial years.

Method 2: 

In the above, the management fee had a ceiling of 1% even in the case of outperformance. This can be partially relaxed as an incentive:

  • Absolute outperformance over the last 3Y: Management fee can be 1.3% for next FY (next review)
  • Absolute underperformance over the last 3Y: Management fee drops to 0.7% for next FY.

To make this work, return before expenses should be disclosed. Other than the will to enforce this, I do not see why this cannot be imposed. One can even use a variant of these rules to keep index funds, especially ETFs in check to ensure minimum tracking errors and price-nav deviations.

Yes, this does increase the risk of malpractice, deviations from mandate etc. to show performance. However, take a moment to consider this. All mutual funds write some standard tedious statements in their scheme documents and write something extra  (strategy, approach, selection etc) in their scheme fliers and distributor promotion material. So it is arguable that the malpractice is already rampant and nothing much will change.

Readers are encouraged to share their views below (or on twitter @freefincal). Do you agree with this? Can this be done in a different manner? Do you foresee any problems? 

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)