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

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.

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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About the Author 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. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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