SEBI, the market regulator in India, is reportedly mulling over allowing mutual funds to impose performance-based fees for managing funds. Currently, mutual fund fees are charged as a percentage of the assets under management, depending on the fund size, and in accordance with regulations for various scheme types.
However, with many actively managed mutual funds failing to surpass their benchmark indices, SEBI is proposing the introduction of a new category of mutual fund schemes that impose performance-linked fees. The performance-based fees permit an additional fee when a fund consistently outperforms the benchmark index and produces higher annualised returns.
What are the benefits of performance-based fees?
The fundamental premise is that the base fees, charged for mutual funds, could be reduced while additional charges would be imposed as per performance. SEBI intends to allow this fee when a fund continuously beats the benchmark index, creating an incentive for funds and fund managers to produce better returns for investors.
Currently, fund managers are paid a fixed fee regardless of how the fund performs, thereby providing them with little motivation to take risks or actively manage the fund to generate higher returns.
One of the significant benefits of performance-based fees is that it provides an incentive for fund managers to work actively to generate higher returns for investors. By introducing performance-based fees, SEBI hopes to encourage fund managers to take a more proactive approach to manage funds, to invest in a more comprehensive range of stocks and securities, and generate higher returns.
How can this move impact the mutual fund industry?
Currently, asset management companies (AMCs) are permitted to impose fees in the form of expense ratios that cover the total costs associated with managing the fund, ranging from 0 – 2.25% of the investment amount.
With the introduction of performance-based fees, the mutual fund industry could experience a shift towards actively managed funds that aim to outperform the benchmark index. This could lead to more competition in the industry as fund managers strive to outperform their peers and attract more investors.
While performance-based fees could lead to a more competitive mutual fund industry, there are concerns about higher costs and excessive risks. It could lead to higher costs for investors, as fund managers attempt to generate higher returns to justify the additional fees.
Additionally, there is a risk that fund managers could take excessive risks in an attempt to generate higher returns, which could lead to losses for investors.
What do the experts believe?
Rahul Jain, President & Head of Nuvama Wealth told MintGenie, “The Securities and Exchange Board of India's (SEBI) proposal to implement performance fees for mutual funds is another step in the right direction. Many actively managed, high-cost funds have historically underperformed their benchmarks, whereas passively managed, low-cost funds have been able to match them. The change is likely to motivate fund managers to improve their performance.”
“The only condition is that higher returns should not come at the expense of increased risk. It remains to be seen whether the investors will ultimately benefit. Because mutual funds cater to retail investors, the performance fee may complicate the overall fee structure. The success of this move is dependent on its flawless execution,” he added.
Adding her views, Sonam Srivastava, Founder & CEO of Wright Research said, “Performance linked fees in mutual funds could incentivize better fund performance but also prompt excessive risk-taking. It seems fair to pay higher fees for higher returns, but the system could lead to benchmark manipulation, with managers choosing easy targets to maximize earnings. The complexity of implementing this in mutual funds, where thousands transact daily, is a logistical challenge.”
“The system might encourage short-term focus for immediate gains, compromising long-term growth. Lastly, while better performance justifies higher fees, unchecked, this could escalate costs for investors. So, while performance-based fees could enhance accountability, the specifics of implementation, like defining 'performance', fee calculation and conflict of interest management, will determine their effectiveness,” she further stated.
Commenting on the same, Mayank Bhatnagar, Chief Operating Officer of FinEdge said, “The reason that we feel that this could be a negative for investors as well as AMC’s is that it may encourage a culture of unnecessary risk-taking within fund managers in the pursuit of alpha. This could in turn result in so-called “big mistakes” that may hurt retail investors and diminish their faith in mutual funds. Such mistakes have been evident in several PMS’s over the years, where fund managers have chased returns in an effort to maximize profit sharing fees.”
“When it comes to mutual funds (which is a retail product), a stable performance that is in sync with an investors planned “goal-target” return is more important than outperformance at all costs. In our view, the best fund is not one that generates alpha, but rather one that remains true to label and manages risks well,” he added.
While there are concerns about higher costs and excessive risks, it could create a more competitive industry, with fund managers working to generate higher returns for investors. Ultimately, investors should weigh the potential benefits and risks of performance-based fees, choose funds that align with their investment goals and risk tolerance, and stay updated on any developments in this area.