Will performance-linked mutual fund fee mean better returns for you? There are a few things that need to be considered before weighing the benefit of such a proposal
To address underperformance by active funds, Sebi is mulling a fee structure that incentivises AMCs to deliver superior outcomes. However, will such a move really help?ET Wealth talks to both sides.
NO: Vidya Bala, Co-founder, PrimeInvestor.in
“This proposal only adds another layer of complexity.”
Sebi’s proposal for a performance linked fee in mutual funds is unlikely to be a gamechanger in an investor’s wealth building journey. There are a few things that need to be considered before weighing the benefit of such a proposal. First, active mutual funds have been struggling to beat benchmarks since the advent of two changes: one, using the Total Return Index (TRI) of each benchmark instead of regular benchmark.
Two, new Sebi categories that necessitated schemes to bucket themselves and invest within the universe mandated. Besides, the nature of stock moves in market-cap weighted indices and the limitation of funds in mimicking such stock weights has also contributed to underperformance of funds over benchmarks. In other words, what is happening today is a structural issue in terms of scheme performance. We don’t think this structural issue can be solved with a carrots and sticks approach to charging variable management fee. A performance-based fee is unlikely to push a fund manager to perform better than the index. Nor is an investor going to benefit by getting a few basis points refunded when the index outperforms by a significant margin.
The right course would have been to stick to the index than the active fund! Second, with an open-ended product like mutual funds, we think investor behaviour takes care of fund flows. Money chases performance. This essentially means a fund that performs poorly cannot garner inflows. This, to some extent, acts as a self-correcting mechanism eventually, to remove excesses in terms of charging high TER when funds cannot showcase performance. The present direction of the MF industry, both in terms of moving to lower cost and passive products, fills the gap created by the structural changes mentioned earlier. A performance-linked fee only adds another layer of complexity to this natural progression and at best serves as a marketing tool for AMCs trying to differentiate themselves.
MAYBE: Nilesh Shah, MD, Kotak Mutual Fund
“Performance fees should not entice higher risk taking or focus on short term performance.”
Most professional service providers like a doctor, lawyer or a chartered accountant don’t charge fees based on performance. In hospital before taking away a dead body, one has to clear bills. There are lot of reports that fund managers aren’t adding value by outperforming the index. One such agency is saying that for the past two decades. While evaluating fund performance, following points needs to be kept in mind.
Index doesn’t keep cash. Most funds keep 5 % cash to provide daily liquidity. Daily liquidity creates around 35 basis point drag for funds.
MFs’ individual stock exposure is capped at 10%. Index doesn’t have any cap on individual stocks. Stocks like RIL, HDFC Bank which have higher weightage in index creates a drag. Ben Graham, the legendary value investor, would have miserably failed as a fund manager as he would not have been allowed to keep half of the portfolio in just one stock.
Index inclusion and exclusion happens at the closing prices. Funds have to bear impact cost.
Despite the above challenges mutual funds have delivered alpha and added value to 3.75 crore investors and hence have grown multi-fold. While cost is a very important aspect of investor return, low cost doesn’t guarantee investor welfare.
Sebi’s proposal of performance linked fees is part of the evolutionary process. For an informed set of investors, performance linked fees will provide additional way of investing. Care should be taken that performance is long term, sustainable and returns are adjusted for risk. It shouldn’t happen that performance fees entice higher risk taking or focus on short term performance. Choosing appropriate benchmark for evaluation of performance is also extremely important to make the concept work. The performance linked fees mechanisms should balance interest of investors, manufacturers and distributors. Let me end with one anecdote. In the days of the dotcom bubble, one lucky fund manager was given performance fees on return above a hurdle rate. In the first year, the fund went down massively. In the second year there was a dead cat bounce. The fund manager retired with performance fees even though clients lost most of the money.
YES: Aashish Somaiyaa, CEO, and Executive Director, WhiteOak Capital Asset Management
“It will take us closer to meritocracy and higher transparency.”
Expecting performance-linked fees to yield better outcomes assumes that fund managers can amp up or down performance based on expected fees. To that extent, it would be simplistic to expect performance-linked fees to yield better outcomes. But where performance linked fees are likely to yield better outcomes for investors and managers is in terms of objectivity and direct correlation of performance to fees. When fees are not linked to performance the connection becomes slightly convoluted and indirect. Then they are linked only to the size of assets managed. But accretion to assets both by way of appreciation as well as new flows is achievable only if funds perform relative to benchmarks and peers. A simple analysis of yearly flows into funds will show that flows chase performance, which means eventually asset managers’ earnings are linked to performance. When fees are linked to performance over a benchmark or hurdle, the connection becomes direct.
But the real and far-reaching difference in a performance linked environment will be brought out by the acceptance that in order to preserve alpha and sustain fees, managers will have to respect capacity constraints of the strategy they practice. Every strategy has an optimal capacity and alpha potential depending on the style, sector and market cap segments it operates in and factors like the number of analysts, coverage universe, number of holdings and portfolio turnover. Strategies that are narrow in terms of style, sector and market cap bias may have theoretically high alpha potential, but they tend to have lower AUM capacity and very volatile alpha. Broad based strategies managed by large teams of analysts covering a wide universe tend to have a higher capacity but with optimal and more consistent alpha. It’s a welcome initiative and will take us a step closer to meritocracy, higher transparency and objectivity in outcomes for investors as well as managers.
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This story originally appeared on: India Times - Author:Faqs of Insurances
