Consolidation gains

Sebi has taken the right call on merger of mutual fund schemes

The Securities and Exchange Board of India’s (Sebi’s) initiative to redefine mutual fund categories and induce asset management companies (AMCs) to merge similar schemes is a welcome step, driving long-pending consolidation in an industry that has hitherto ignored informal requests for ending the surfeit of plans. In the long run, it will lead to more clarity and should result in lower expense ratios, making it easier for investors to select funds that suit their specific aims. The Indian mutual fund industry is one of the world’s largest and consists of 42 AMCs, which together manage over 55 million folios and hold over Rs 20 lakh crore in assets under management (AUM). The AUM has more than doubled in the past three years and individuals now hold around 48 per cent of the total AUM. 

However, size does not necessarily translate into efficiency or low expenses. The space is bewilderingly complex with over 2,000 active schemes investing in assorted mixes across various categories of debt and equity. Globally, fund expense ratios tend to average between 1 per cent and 1.7 per cent of AUMs in most markets. But Indian funds typically charge above 2 per cent of the AUM, which is almost double that of the US and higher than any other major market, except Canada. The excessive expense adds up to over Rs 150 crore per annum that is not being gainfully invested. Over time, that compounds to a massive opportunity cost. 

Part of the problem lies in the current loose categorisation of equity and debt and close-ended versus open-ended funds. Funds are allowed to charge differential expense ratios for debt, equity and balanced funds. An equity scheme can charge a maximum of 2.5 per cent of the assets managed while debt funds can charge 2.25 per cent. A new fund offering can charge up to 0.3 per cent as promotional expenses for marketing in smaller towns. AMCs have an incentive to game this system to squeeze out higher charges and often float multiple schemes with different names but similar mandates. 

AMCs have also been known to ignore the stated mandate and allocate assets in a fashion that the investor may not necessarily prefer. For example, a stated small-cap scheme may have substantial exposure to large-cap stocks. All this confusion makes it difficult for investors, especially individuals, to select schemes. Sebi’s Mutual Fund Advisory Panel has recommended that categories should be fine-tuned and tightened, and mandates should be strictly followed. This implies a merger of similar schemes offered by the same fund house. This will make it considerably easier for investors to build rational portfolios that suit their specific need for diversification. 

If the investor decides to simply continue holding some merged schemes, there are no tax implications. But this process of consolidation could have tax implications in cases where investors decide that the merged scheme does not suit their risk appetite or timeframe. In that scenario, they will sell and move to another category and there may be capital gains payable, depending on the holding period and returns. Nevertheless, the removal of ambiguity will help in the long run. As schemes become larger through this merger process, the regulator should also look at lower caps on expense ratios.