The capital markets regulator has proposed to lower TER by 10-15 basis points across slabs for open-ended schemes and 20-25 bps for close-ended ones. It has also proposed capping brokerage charges for cash transactions to 2 bps from 12 bps earlier and for derivative trades to 1 bps from 5 bps. Apart from these, Sebi has made a provision for enabling expense ratios to be charged on the basis of the performance of a scheme. This would be optional for AMCs.
Notably, a long while back, Sahara Mutual Fund had experimented with performance-based fees in its schemes. However, the concept didn’t pick up as the mutual fund’s registration was cancelled by Sebi in July 2015 and all the schemes of the fund house were subsequently wound up.
How could performance-linked expense ratio work and would they benefit retail investors?
Difficult to implement
Sebi has always wanted to allow performance-linked fees—this has been coming up, with a fair bit of optimism, in regulatory discussions for nearly 15 years.
The sticking point has never been intent, it’s the execution, says Dhirendra Kumar, CEO, Value Research. He points out that the real bottleneck is benchmarking and daily NAV adjusted for expense every day.
“In theory, if a fund beats its benchmark, it should be allowed to charge more. But in an open-ended fund, NAV (net asset value) is calculated every day. You can’t say, ‘we outperformed last year, so we’ll charge higher fees this year.’ And if expenses are being charged daily, you would, in effect, have to demonstrate benchmarkbeating performance every single day. That’s just not workable in an open-ended structure. Which is why performance-linked fees, though attractive in principle, are impractical for open-ended funds,” he explains.
This can work in closed-end funds, where money is locked in and performance can be assessed over a defined period, and fees settled at the end. “So, the intent is good, but the open-ended fund design makes it unworkable,” adds Kumar.
Better suited for PMSes
Experts feel that performance-linked fees are easier to apply in individually managed portfolios, such as portfolio management services (PMSes), but mutual funds are pooled structures, making profit-sharing difficult to implement fairly.
Typically, PMS structures combine a fixed management fee with a performancelinked fee. The latter is charged only when returns cross a predefined hurdle rate. For instance, if the hurdle is 8% and the portfolio earns 12%, the fee applies only to the excess 4% return. This hurdle can either be a fixed return threshold or a benchmark index such as the Nifty.
“Still, Sebi’s proposal is a positive push toward performance-based accountability. The model must reward consistent benchmark outperformance, not market-driven gains, to ensure investor fairness and preserve the mutual fund structure’s core principles,” according to Feroze Azeez, Joint CEO, Anand Rathi Wealth.
Vidya Bala, Co-founder, Primeinvestor. in, believes that a fixed-fee structure offers better clarity and predictability for mutual fund investors. “Just to get a slightly lower fee during downturns, why should investors have to share a meaningful portion of their upside returns?”
Impact on industry
The advantage of mutual funds is that unlike PMSes, there is no tax on buying and selling within the fund. “But to generate better returns, funds may go towards more concentration and that can increase risk (theoretically), which is expected in PMS in general, but mutual fund investors may or may not be expecting it,” says Kirtan Shah, Founder and CEO of Truvanta Wealth.
Another fear is that a performancelinked fee model in mutual funds could compromise fairness for investors. If the structure is designed around absolute performance, it may provoke fund managers to take risk simply to trigger performance incentives.
“The fund goes through cycles, and every fund has its own style of management, so tying costs directly to shortterm performance can be counterproductive. The goal of a fund manager should be to generate consistent alpha over the benchmark, not to share profits,” says Azeez.
When incentives are tied too closely to outcomes, fund managers might feel pressured to chase temporary market opportunities or take risky bets to boost returns. There is also a risk of mis-selling. Distributors might promote funds with the promise of higher potential returns in the short term rather than suitability or risk profile.
Better parameter
According to experts, if performancelinked fees are to be considered, using rolling returns compared to trailing returns would be a more balanced approach than looking only at annual performance. Rolling returns capture the fund’s consistency over multiple periods and smoothen out the impact of short-term volatility.
“However, this approach may bring certain challenges, as fund managers could feel unnecessary pressure to alter their investment style or strategy merely to earn performance incentives. While rolling returns provide a more reliable picture, the structure must be designed carefully so that it rewards steady alpha generation without penalising style or market-driven variations,” says Azeez.
Final thoughts
While a detailed framework on performance-linked fees would be finalised separately by Sebi in consultation with stakeholders, experts feel that this can bring in higher accountability on fund managers when it comes to performance.
“At the same time, we have natural in-built mechanism in mutual funds where underperformance or overperformance gets rewarded by higher inflows or penalised by redemptions from the scheme,” says Deepak Chhabria, CEO of Axiom Financial Services. Experts feel that a well-calibrated model can bring accountability without disturbing the core principle of fairness that mutual funds stand for.