India’s capital markets regulator, the Securities and Exchange Board (SEBI), has fined DSP Investment Managers, the asset manager of DSP Mutual Fund, and its trustee company (DSP Trustee Co) in what may be the first case of its kind for the costs of one of the schemes ratios.

The case involved the DSP Nifty 50 exchange-traded fund (ETF), which has an expense ratio of 0.16%. However, since the DSP Nifty 50 ETF (DN50) launch in December 2021, fund houses have only charged an expense ratio of 0.07% to the scheme. DSP Investment Managers absorbed the balance (0.09%) on its own books. The project has an official expense ratio of just 0.07%.

SEBI objected to this, saying it breached a circular issued by the regulator in October 2018. The notice requires fund houses to charge schemes for all scheme-related fees. The circular states that no payment shall be made from the books of Asset Management Corporation (AMC) or its affiliates, sponsors, trustees or any other firm.

SEBI has imposed a fine of Rs 100,000 on several fund houses and trustee companies. Launched in December 2021, DN50 raised Rs 11.81 crore. Its corpus has increased to Rs 11.89 crore by year-end and Rs 22.59 crore by March 2022.

In their defence, fund houses say the cost of running an MF scheme, even a passive scheme like an ETF, drives up overall costs, which could make the scheme (DN50 in this case) underperform compared to its peers. Attractiveness. “Thus, if the scheme bears all expenses, the scheme’s operating costs as a percentage of AUM (assets under management) will initially be high as it plans to expand its AUM,” the fund house wrote to SEBI June 2022, as part of its defence.

It argued that it would be an outlier if the scheme were to cover the total operating expenses (0.16%).

To be sure, SEBI allows a maximum total expense ratio (TER) of 1% for passive funds such as ETFs and index funds. Many passive funds charge far less than that to remain competitive. According to ACE MF, the average expense ratio charged by large ETFs (the category the DN50 falls into) is 0.08%. Data is available for 31 of the 33 large-cap ETFs. Thirteen of these ETFs have expense ratios as high as 0.07%; DSP Investment Managers charge DN50.

Index funds charge slightly more, and according to ACE MF, they charge an average expense ratio of about 0.29%.

The fund house argues that to scale, it needs to keep costs low (albeit by charging the scheme an artificially low expense ratio) to make it attractive to investors. “If TER increases, it will further deter investors from investing in the scheme, limiting its ability to increase AUM. As AAUM (average assets under management) increases, operating expenses as a percentage of AAUM will gradually decrease, and total scheme expenses will lower than that charged by TER,” AMC wrote to SEBI.

In 2018, SEBI issued a circular requiring fund houses to charge only scheme fees for all MF scheme-related fees. Ban asset managers from charging fees, a practice that has prevailed for years in the Rs 40 trillion Indian MF industry. It is a common practice in the industry to attract dealers by taking them on a trip abroad. The 2018 notice put the brakes on the spending power of fund companies. Keeping all fees within the planned TER ensures that fund houses keep costs manageable.

DSP argues that the ETF does not pay distributor commissions because ETF units are bought and sold on the stock exchange. The intent to absorb some of the project’s costs is evident. Hence, it added that it complied with SEBI’s 2018 circular. The fund said SEBI’s 2018 circular banning asset managers from charging fees on their own books was to prevent mis-selling.

But DSP Investment Manager’s most prominent defence is that the total fees it incurs on DN50 (costs absorbed by AMC plus fees it charges to the scheme; 0.16%) are well below SEBI’s 1% passive investment cap for funds. According to its interpretation of the SEBI Act, since the total cost of DN50 (0.16%) is well within the upper limit of SEBI (1%), the fund house does not do wrong to bear part of the cost, especially considering that no one is worried, intending to distribute Pay any additional commissions and induce improper sales.

In 2019, SEBI did allow asset managers to charge a portion of the book, which is limited to two basis points of scheme assets, provided the scheme’s costs exceed the payout cap (1% for ETFs). A basis point is one-hundredth of a percentage point.

In this regard, the fund company also pointed out that SEBI did not prohibit the fund company from bearing part of the plan costs. SEBI said the portion absorbed by fund houses (0.09%) is still well above the absorption limit (0.02%) that SEBI will eventually allow in 2019.

Further, SEBI also said in its order that the offer document for DN50 did not mention that Fund House intends to absorb its 0.09% cost, although it clearly mentioned that it would absorb the scheme’s new fund offer-related fees and include this NFO fee.

The fund house also claimed in its defence that it voluntarily disclosed this information to SEBI as part of the quarterly test reports that all AMCs must submit to SEBI and as part of its semi-annual trustee reports, whether at the end of the reporting period in March 2022. This brought SEBI to the attention of the actual situation of fund houses and DN50, esp.

SEBI has argued that these reports are exclusively for fund houses and trustees to report any discrepancies from SEBI rules. The fact that fund houses and trustees refer to the overabsorption of TER in these reports shows that they are aware of the consequences.

In its order, SEBI reiterated that it was wrong for asset managers to have charges on their books. This adds to SEBI’s order book and could give big fund houses with deep pockets an unfair advantage over smaller asset managers.

SEBI’s penalties on DSP investment managers appear insignificant compared to the penalties usually imposed. But the order is significant given the regulator’s recent announcement that it has begun a review of fees and expenses charged by mutual funds. On the one hand, is DSP Investment Managers’ defence that costs need to be competitive to attract investors, a view arguably shared by many other fund houses. On the other hand, SEBI’s intention to revisit mutual fund costs may also look costly, especially considering that it recently cut costs in September 2018.