Active Versus Passive Funds

In the Mutual Funds industry, Alpha is the incremental performance that the fund manager generates vis-a-vis the benchmark such as Nifty and Sensex.

ETFs as a rule have minimal expense ratios since they do not offer active fund management. It's like a technology platform. Since it does not have to pay a fund manager it is able to charge fees which are lower than actively managed funds.

Most Index ETFs today charge fees ranging from 0.05 to 0.15% whereas most active equity funds in India charge in excess of 2%.

In an imperfect and developing stock market like India, there is still information asymmetry. It is reducing gradually as SEBI ramps up its vigilance, the outperformance of active funds is under stake.

According to Pawan Agarwal, the nexus of brokers had its good days in the late 1900’s and early 2000s. Money was being made and lost by rigging up prices all the way up and then down. While brokers, in cahoots with the promoters, were making a lot of money, innocent investors were burning their hands. The shady practices are one of the reasons why stock market investment never took off among Indian retail investors.

Alpha Squeeze in Indian mutual funds

The Americans were the first to fall in love with passive funds. Convinced about Alpha squeeze and low expense ratios, active funds in the US in 2016 saw a net outflow of $326 billion compared to passive funds. The passive funds reported a net inflow of $429 billion.

Developments in India

SEBI has capped the expense ratios of equity mutual funds to 2%  per annum and debt MF to 2.25 % per annum. It abolished entry loads, which means no upfront fees from clients. It also reduced distributors' incentives to a large extent.

When the fund houses started paying distributors an up-front commission, then SEBI, through AMFI, introduced guidelines stating that the upfront commission that a fund pays a  distributor cannot be more than 1%.

The guidelines also placed restrictions on trail commissions and mandated that for subsequent years, it should not be higher than that of the first year.

Direct schemes: SEBI’s knockout punch

• In 2007, SEBI launched direct schemes.
• Least possible expense. No Commission to brokers.
• It gives investors an option to deal directly with any fund house without any intermediaries.
• The process to buy the schemes remains the same except that the investor keeps the broker code field empty in the mutual fund application form.
• In 2013 SEBI mandated that all Mutual Funds had to have a direct option for all schemes 
• The fees came down to almost half the expenses charged by conventional Mutual Funds due to disintermediation of the brokers. 

Result:

• 38% of Industry Assets are under direct schemes. 
• In Debt funds, 61% AUM is under direct schemes.
• In equity funds, 13 % AUM is under direct schemes.
• These numbers will keep rising as this trend is irreversible.
• In 2013, regulators announced that an intermediary can only be an advisor or a distributor and not both. A distributor cannot recommend a fund.
• According to the new regulatory construct, an advisor cannot earn anything from the schemes he is recommending. He earns only an advisory fee of 0.1 % and 1% of acid advice directly from the client which is the part of the contract between him and the client.

This contract and fee construct now aligns the investors' interest with that of the advisor because the client now invests in direct schemes and the distributor does not get any commission from the product he is recommending.