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.

performance linked expense ratios in mutual funds

Published: December 2, 2019 at 1:45 pm

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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.

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-0.116.116.36
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.

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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? 

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
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8 Comments

  1. The crux of the matter is that even if I want to move from so called “actively managed” funds to some Index based fund, what choice do I have.
    It is requested to share a few of the well researched and well-aged (means have been around for quite some time) from stable and good fund houses, say, for example, Top 5 or 8 fund houses, such Index based funds which cover Nifty next 50, Nifty 500 or such combination which you have talked about in your previous post dated 7 Feb 2019.
    If I do not have a credible choice, then, I have to perforce go for an “actively managed” fund.

  2. Couple of things come to my mind 1) All funds which have not completed min 5 years with same mandate should be having a ceiling in expense ratio irrespective of performance. 2) Instead of linking expense ratio to only last 3 year performance, it can be linked to the average of the last three 3 year performances – Every year, the most immediate 3 year performance gets added and the farthest 3 year performance gets removed. This way, the expense ratio jump/fall is gradual for both investor and fund house while at the same time incentivising consistent performance. We can look at a weightage for the different 3 year performances but that will make it slightly complex.

  3. Why not do something like Shephershill or Banyan Tree PMS? Let the index return be the hurdle rate and the expense ratio of the index fund be the base rate and let the fund charge an additional expense as a percentage of the excess.

  4. Ever since mutual fund industry was opened up in India, the market regulator came up with a series of reform measures to tame the industry with good results and luckily for the investors, So,there is no reason why the above suggestion cannot be implemented, except as pointed out by you i,e lack of willpower . Even the fee of index funds in our country is very high,particularly in the case of Nifty next 50 index funds. I fail to understand why there is so much of disparity between Nifty50 index fund fee andNifty Next50 index fund fee, when the fund manager has no role or marginal role to play in the index funds. So that is one area where the fee has to be considerably reduced.

  5. As I have said before, at the least – making the TER components and calculation to be mandatory declared would be a welcome first step! That itself will reveal the way fund houses are accounting for the respective heads which eventually add upto the final expense ratio.
    IMO, that will also have the second order effect of rest of points taking care by itself and I would even argue, that it might have the added benefit of fund itself being better managed!

    Thanks

  6. I think this is a bad idea.

    1. Idea of performance linked fee is more in the domain of hedge funds and not in mutual funds.

    2. Small funds will fold as they may find the return per fund drop if this is implemented. Lots of funds start with small AUM and then get bigger as time goes by. Asking them to reduce fee will hit them adversely if the AUM is small and if they are having a bad streak (Remember, most funds have bad streaks)

    3. Government shouldn’t dictate how much AMCs must charge. They can introduce reasonable limits but over-regulation is inherently bad.

    4. Just because one fund hasn’t beat the benchmark in 3 years why force them to cut fee? Did they promise that they will beat a given index?

    5. Funds that performed well for 2 years may take it easy in the third year. 3-yr return is arbitrary benchmark. Why not just last 1 year which might be a better reflection of macro?

    6. Above all, why the infatuation to ‘beat-the-index’? Investing is more about managing risk than managing returns.

    7. Markets can be irrational for extended period of time. The duty of fund manager is to stick to the investment mandate. This is non-existent in an index fund.

    8. Developed countries with a very liquid market provide a different avenue for mutual funds compared to developing markets. So, adding more regulations could impede competition and much needed retail penetration.

  7. Hi Sir,

    An excellent and very appropriately timed article. This question came into my mind several times in the past and I always thought that the MF fees should be linked to its performance.

    As you highlighted in your past articles “Even if fund perform after a long period of downturn, your goals will not wait for the fund to perform”.

    The Quantum and ICIC Val Dis have shown dismal performance over last 5 years. You mentioned this in one of your past articles, and I luckily switched from Quatum to Kotak Standard Multicap.

    I am keenly checking the ICICI Val Dis and thinking of switching it in near future.

    Thanks for the analysis you are doing on a regular basis.

    Thanks.

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