Analysing SEBI’s TER proposal: AUM growth vs profitability, a misplaced concern, says report

• Market regulator SEBI has recently suggested making TER (total expense ratio) all inclusive with taxes, transaction and brokerage costs, etc.
  
• This proposal has sparked concerns about the potential impact on the profitability of asset management companies (AMC)s.
  
• The ability of a fund to generate positive alpha is a significant factor in influencing both direct, and intermediated flows.
  

Investors are concerned that a high pass-through of TER (total expense ratio) cut with distributors can majorly affect AUM (asset under management) growth of AMCs. However, according to a report released by Kotak Institutional Equities, the AUM is expected to be safeguarded against induced churn, as the frenzy seen during new fund offers (NFO) is unlikely to be repeated.

TER is a measure used in the investment industry to calculate the total cost incurred by a mutual fund in managing, and operating the fund. TER includes various expenses such as management fees, administrative costs, distribution charges, and other operating expenses associated with running the fund.

The market regulator has recently suggested a proposal to include taxes, transaction costs, brokerage fees, and other related expenses in the TER. However, this proposal has sparked concerns about the potential impact on the profitability of AMCs. Including these additional costs in the TER calculation could potentially reduce the net returns generated by the funds, making it challenging for AMCs to maintain their profitability levels.

The impact of reduced commissions

According to the report, the implications of TER regulations should be analysed in relation to two key factors, the current level of AUM which are relatively more resilient to variations in commission rates, and the incremental flows, which are influenced by both performance, and distribution payout, with performance potentially exerting a greater influence.

With respect to HDFC AMC and, to a lesser degree, Nippon Life AMC, there is a concern of apparent trade-off between maintaining profitability, and being competitive in terms of the ability to pay distribution commissions.

In this context it should be noted that HDFC AMC has experienced a significant revival in flows over the past 6-12 months compared to the industry as a whole. This revival has occurred even though HDFC AMC pays lower commissions than many other large competitors in the same category. Any potential impact on growth resulting from lower commissions could be offset by a potentially stronger alignment of interests with HDFC Bank, the new parent company, the report says.

Fund performance drives net flows

The report observes that there exists a notable correlation between alpha (excess return) and the net flows of funds. Funds that consistently deliver strong alpha tend to attract attention, and experience increased inflows, while those with weaker alpha may see outflows. This correlation indicates that performance plays a crucial role in investors' decision-making process.

Not only do direct channels show a high sensitivity to fund performance, but intermediated channels such as banks, independent financial advisors (IFA), and national distributors also heavily rely on performance when recommending funds to their clients. Therefore, the ability of a fund to generate positive alpha is a significant factor in influencing both direct and intermediated flows into a fund.