Fortune India Explainer: Sebi’s plan to simplify mutual fund charges may drive a shift toward passive funds

The regulator, Securities and Exchange Board of India (Sebi), has proposed a sweeping overhaul of how mutual funds charge investors, aiming to make costs more transparent and investor-friendly. The regulator’s consultation paper recommends reducing the Total Expense Ratio (TER) — the fee that covers fund management and operational costs — to ensure investors pay less while understanding charges more clearly.

According to SEBI, the move could significantly cut investment costs and promote greater transparency in the ₹50-trillion mutual fund sector. However, the reform poses immediate challenges for fund houses. Asset Management Companies (AMCs) are likely to face pressure on profitability as their fee income declines.

Speaking to Fortune India, Santosh Meena, Head of Research at Swastika Investmart, said larger fund houses will bear the brunt of the change due to their higher asset bases. While SEBI has offered smaller schemes a 5-basis-point TER relief, Meena noted that this will offer only limited respite to AMCs.

Q. Do lower TER limits risk reduce the quality of fund management or research, especially for actively managed schemes?

A. There is a real risk for active schemes, as reduced revenues (lower TERs and lower brokerage limits) will force AMCs to cut costs, potentially leading to lower spending on proprietary research and on experienced fund management talent. This pressure will be most acute for schemes that already struggle to outperform their benchmarks. The industry may consolidate, favouring only those active managers who can justify their fees with superior, net-of-cost performance.

Q. Will increasing transparency around total costs — including brokerage and statutory levies — change investor behaviour when selecting funds?

A. Yes, this will change the mindset of investors significantly. Separating fund management fees from hidden costs such as brokerage and statutory levies will make investors much more cost-aware. This step will accelerate the shift towards low-cost options like direct plans and passive funds, as investors demand concrete, consistent alpha (outperformance) to justify paying higher active management costs.

Q. Do you think that performance-linked fees can lead to better outcomes for investors, or might they encourage fund managers to take excessive risks?

A. Performance-linked fees can lead to better outcomes by directly aligning the fund manager's incentives with the investor's interests (i.e., outperforming the benchmark). However, they also carry the risk of encouraging excessive risk-taking (speculative trading) by managers trying to hit performance hurdles. The success of this model will depend entirely on SEBI's regulatory safeguards, such as implementing strict "High-Water Marks" to prevent fees on recovered losses.

Q. How much could investors realistically save in long-term returns if SEBI’s proposed cuts to expense ratios are implemented?

A. The proposed reduction in TER would surely affect investors, as it reduces the overall cost for them to invest in mutual funds. Even a small cut in TER compounds into meaningful gains over the long term, improving investors' net returns, while promoting greater fee transparency in the system.

Q. How much could investors realistically save in long-term returns if SEBI’s proposed cuts to expense ratios are implemented?

A. The cost gap between big and small fund houses will therefore narrow down, with lower TER caps and curbs on additional charges likely to make the playing field more level. But the squeeze on profitability for large AMCs could accelerate the industry's shift toward low-cost passive products, with active fund managers facing growing pressure to justify higher fees through consistent outperformance.