Discover more from Boring Money, by Shreedhar
SEBI wants to change how mutual funds make money
Or how the market regulator doesn't entirely trust market forces
Here’s how mutual funds make money:
An investor gives the fund some money to manage
The fund manages it by investing that money in stocks, bonds, etc.
The mutual fund company charges a management fee for this service, which is a fixed percentage of whatever it manages
The incentive here is clear. The fund needs to increase the amount of money that it manages. One way for a fund to do this is by, well, investing well. If a fund’s investment goes up in value, it automatically manages more money. But investing well is hard, slow, and not a lot of fun. The fun way to manage more money is just getting more money from your investors. That way, the fund needn’t worry too much about how the fund performs, the company running the fund makes money either way.
Last month, SEBI released a consultation paper that reevaluates how mutual funds charge for their services. The paper has 15-odd proposals but I’m only writing about the couple interesting ones. Here’s a post from Zerodha that summarises all proposals, if you’d like to see them all on one page.
SEBI doesn’t particularly like that the only way for mutual funds to make money is by accumulating more money from investors. One solution it’s considering is to allow mutual funds to charge not just for money management, but for performance. Sure, let mutual funds take some money for managing these assets, but if the fund performs well, give the fund company a decent chunk of the profits as well. That’s how hedge funds work, and arguably they do have a lot more fun with their investments.1
Here are two possible approaches that SEBI is considering:
Approach A: During the period in which the investor remains invested, the base expense ratio may be charged to the investor. At the time of redemption, the management fees may be charged if return of more than indicative rate is generated or annualised returns received by the investor is above the hurdle rate.
Approach B: There can be another approach where higher expense limit for performance based TER [percentage fee] may be fixed and TER inclusive of management fees is charged to the investor. The TER charged by the schemes in such cases should be based on the schemes’ performance during the previous year. At the time of redemption by the investor, if AMC fails to generate return above the indicative returns for investor or the annualised returns for the investor is below the hurdle rate fixed in advance, the AMC may retain base TER as may be applicable and return the remaining expenses charged to the investor, along with the redemption amount.
In Approach A, if you invest in a mutual fund, you’re charged the regular management fee right until you withdraw your money. When you do withdraw, the fund deducts a nice chunk from your profits (beyond a certain agreed upon threshold) and returns the rest. In Approach B, the fund just charges you a higher management fee to begin with. When you actually withdraw, it calculates your profit and returns any extra money it might have charged earlier.
This is very different from how hedge funds are paid! The general rule with investments is that you’ll have good years and you’ll have bad years. If a hedge fund has a good year, it’s going to charge for performance right away and take away its share of the profit before it gets to a bad year. If a SEBI-regulated mutual fund has a good year, it’s not going to be paid until the investor withdraws! In the management fee model, a mutual fund is incentivised to convince investors to invest as much as possible. In this performance fee model, a mutual fund is incentivised to convince investors to.. withdraw?
I really understand what SEBI is trying to do here. Hedge funds take a lot of risk and often go crazy. If the risk pays off, they’ll earn a lot that year. If the same risk doesn’t pay off the next year, bahh, the investor might lose half their capital but at least the hedge fund got paid the year it did do well. Going by SEBI’s proposal, mutual funds will have to care about their investors’ real returns which will be a mix of both the good and bad years. Sure, it might work. But I wouldn’t be surprised if mutual funds just get their investors to withdraw more often to lock-in their share of the profits.
Grass is greener on the side of the new fund
A well known phenomenon of the Indian investment market is that investors don’t invest by themselves. They need a bit of a push and prod. Even if they want to invest, they need help with how much and where.
Mutual fund companies rely on distributors to sell their funds to end customers. Because, well, most investors don’t ever download an app and start investing. They buy through distributors who they trust! In return, these distributors also get a fixed percentage fee, just like the mutual fund company itself.2 Since these distributors sit in-between the mutual fund company and the investor, it gives them quite a bit of power.
Of course distributors abuse this power. Paraphrasing from SEBI’s consultation paper:
If a mutual fund company is starting a new fund, it will ask its distributors to convince investors to buy this newShinyFund. This newShinyFund will give distributors a higher-than-usual distribution commission
The distributor now goes to their customers and asks them to invest in this newShinyFund because it’s new and shiny. But the customer won’t just have large chunks of money lying around to invest. So the distributor will say “hey why don’t you just transfer your money from oldBoringFund to newShinyFund—I’ll do it for you”
The customer says “yeah, cool” and they’re now an investor in newShinyFund which pays more to both the distributor as well as the mutual fund company
27% of the money in new mutual fund schemes launched between April 2021 and September 2022 came from old mutual fund schemes. In one case, this figure was over 55%. Over time, newShinyFund would become oldBoringFund, and the mutual fund company could just launch a newNewShinyFund and well, distributors would then sell that and life would go on.
SEBI’s proposal is ending this! If a distributor switches an investor from oldBoringFund to newShinyFund, but oldBoringFund pays less commission than newShinyFund, they still get paid the lower commission even if their customer is now switched into newShinyFund. I’m sure mutual funds and their distributors will find a way around this sooner or later, but for now, the incentive to push new funds is lost.3
They see me regulatin’, they hatin’
One way of looking at SEBI is that as a regulator it needs to ensure there’s transparency and let market participants handle the rest. SEBI is, after all, a market regulator, so it would be a bit weird if it didn’t believe in market forces.
Going by this line of thought, SEBI wouldn’t propose barring distributors being paid more to switch their customers into new funds. If a mutual fund company wants investors in its shiny new fund, and it’s willing to pay distributors more to achieve that, why does SEBI see it as a problem? Its job is to ensure that the investor knows what’s happening, but then it’s up to the investor to choose what they want to do.
I can imagine a solution that wouldn’t limit how much commission distributors get, but instead force them to explicitly inform every investor just how much more money they stand to make if the investor buys into the new fund. “Hey there’s this fund that’s great and you should invest in it maybe. It’s new and shiny, can I transfer your money to it, pretty please? If you say yes, I get to take my wife and kids to Europe this year.” I’m sure some investors would say yes, but presumably the majority would not.
Here’s an Investopedia piece on the “9 Biggest Hedge Fund Failures”. Hedge funds, even those managing billions of dollars, often take on a lot of risk and frequently implode. Mutual funds rarely (never) do.
These days, it makes little sense for anyone to invest via a distributor and lose money in the form of a lifelong commission. There are tens of fintech apps which allow for direct investing, as do almost all mutual fund websites.
The SEBI regulation applies when a distributor “switches” their customer’s money from one fund to another. If the same customer first withdraws their money, then re-invests in the new fund recommended by their distributor, the distributor can then get the new, higher commission. Definitely a more annoying and time-consuming process though.