Recently, the Securities & Exchange Board of India allowed fund companies to charge more to investors through a convoluted formula. The practices of fund companies, anyways, were to charge more, not less because investors are usually blind to fund charges, being focused more on returns

The new rules announced by the Securities and Exchange Board of India (SEBI) at its recent board meeting allow asset management companies (AMCs) to charge a higher total expense ratio (TER) in order to increase the penetration of mutual funds. Investors, on the other hand, would have to sacrifice a portion of their returns for the business expansion, or rather benefit, of the asset management companies. According to the SEBI circular, “AMCs will be able to charge 30 basis points (bps) if the new inflows from these cities/towns are minimum 30% of the total inflows. In case of lesser inflows the proportionate amount will be allowed as additional TER.” The additional TER will be on the full fund corpus and not just only the fresh inflows. Instead for focusing on reducing costs SEBI has rather given AMCs the leeway to charge more from the investors.

But what has been the practice of fund houses when it comes to charging TER? As per the existing regulation, the TER which includes the management charges, marketing and selling expenses, brokerage costs and costs related to investor communications, audit fees, etc, cannot exceed 2.5% for equity schemes and 2.25% for debt schemes. In case of an index scheme or exchange traded fund, the total expenses of the scheme should not exceed 1.50%.

As per the new rules, AMCs would be able to charge up to a maximum of 30 bps additional. Fund companies usually disclose the maximum TER they would charge in the scheme information document and more often than not they quote the maximum permissible. Many fund companies charge much lower than the maximum suggested but it does not mean that what they charge for a particular month will be the same a few months down the line.

In fact, the maximum TER charged is already too high for debt and index schemes. Fixed income assets barely deliver returns slightly above inflation and from that if 2.25% is deducted it makes these schemes no better than bank fixed deposits. And the TER charged for index schemes is a total rip-off. All the fund manger needs to do is to invest blindly in the stocks according to their weightage in the index.

For liquid schemes; nearly 80% of the schemes charge a TER between 0.15% and 1%, which is a wide range by itself, but there are still a few schemes that have a TER above 1% and going up to 2.25%. Imagine for a scheme which returns just around 6%-8% per annum and out of that 1% to 2% is deducted by the fund company. For such schemes the return would work out much lower than a bank fixed deposit. Does it make sense to pay for such performance?

The actual TER of a scheme varies considerably and the fund company has to make a notification just two days prior before changing the TER. In fact a couple of years back SEBI observed that fund houses were frequently changing the expense ratios of liquid and short-term debt schemes. Most of the schemes highlighted by SEBI were of debt and liquid fund category. But since then nothing much has changed.

Since the start of the year as many 87 out of 211 equity schemes have changed their TER. 29 out of 74 income schemes have changed their TER and nearly half of the 57 liquid schemes have made changes to the TER.

One should not get fooled if the TER is much lower than the norm. There are many schemes which have had an initial TER which was substantially low but they have only gone to increase it a few months later. And this has been the case in all types of schemes. Edelweiss Equity Enhancer Fund from September 2009 to January 2011 had a TER around 1%. However from June 2011 onwards the TER has been as high as 2.49%. Imagine schemes from LIC Nomura MF, HSBC MF and JM Financial all of which run poorly managed schemes which have delivered substandard returns are charging the maximum TER of 2.5%. And some of the better managed schemes are charging a much lower TER.

Even if the TER is constant over a period, this does not mean the mean that the fund company cannot increase it. Take the case of Axis Equity Fund, it scheme was charging a TER of 1.79% in March 2010, over the next two years the TER has increased to 2.20%. Same has been the case with HSBC Unique Opportunities fund—in December 2008 the TER was around 2% and over the year it has increased to 2.5%. Over time one would expect their assets under management to increase and the TER would come down. But this has not been the case and the TER has increased over time.

These are just a couple of examples from equity schemes. For debt and liquid schemes it has been much worse. The fluctuation in the TER is much more and the fact that it can go up to 2.25% is a scary thought.

What can an investor do in such cases? Not much. It is the regulator’s job to resolve such discrepancies. The TER should be based on the performance of the scheme as well and not only the fund corpus. And the maximum TER charged should be made reasonable for the investor in the liquid and debt schemes. In order to revive the fund industry the regulator would consider increasing expense ratio, but this may mean greater leeway for the fund company to play around.

Take the example of index schemes—here the maximum TER allowed is 1.50% a percentage lower than that equity diversified schemes. Considering the low limit, fund companies do not play around much with the TER and it is usually around 1% to 1.5%. Therefore putting a reasonable limit fund companies either charge the maximum or a little lower. Hence, there is not much variance for the investor to get worried about.