The Securities and Exchange Board of India (SEBI) is considering allowing mutual fund (MF) schemes to charge performance-based fees for managing funds. Currently, the fee is charged as a percentage of the assets under management (AUM), taking into account the fund size, subject to regulations for various types of schemes.

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The proposal

With many actively managed mutual funds failing to beat their benchmark indices, market regulator is proposing the introduction of this new category of MF schemes with performance-linked fees.

“The proposal is similar to the fee structure of Portfolio Management Services (PMS), where the fund would charge upfront fees and levy a performance fee beyond a specified hurdle rate,” Gopal Kavalireddi, Head of Research at FYERS told CNBC-TV18.com.

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PMS is a professional financial service where skilled portfolio managers and stock market professionals manage the equity portfolio with the assistance of a research team.

Here's a look at top 5 PMS and mutual funds:

The impact

Kavalireddi thinks that this regulation is an investor-oriented move geared towards providing higher returns.

"Over the last few years, SEBI has actively engaged in bringing about changes in investment regulations, supporting the journey of retail investors. This new proposal seems apt in the current context, as few mutual fund schemes have severely underperformed over a long time while some have delivered excellent returns comparable to the top PMS schemes," he said.

Echoing similar views, Saurav Basu, Head – Wealth Management at Tata Capital feels that the initiative will incentivise fund managers to focus on generating better returns for investors, as they are directly tied to the fund's performance. However, he thinks that there are potential downsides to performance-based fees as well.

"For example, fund managers may take on undue risk to try to achieve higher returns and earn higher fees, which could ultimately affect investors," Basu told CNBC-TV18.com.

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Vinayak Magotra, Founding Member at Product at Centricity also feels that the move is a subject of debate among investors and industry professionals.

"While some argue that such fees can improve outcomes for both investors and fund managers, others have concerns about their effectiveness and potential drawbacks. On the one hand, performance-based fees can align the interests of fund managers with those of investors, as managers are incentivised to maximise returns rather than simply collecting a fixed management fee. This can result in greater effort and skill on the part of the fund manager, leading to improved outcomes for investors," Magotra said while talking to CNBC-TV18.com.

On the other hand, he thinks that there are concerns that performance-based fees can lead to excessive risk-taking by fund managers in pursuit of higher returns.

"In addition, such fees can be complex and difficult to understand for investors, leading to confusion and potentially discouraging participation," Magotra added.

The bottomline

Overall, while performance-based fees have the potential to improve fund’s performance outcomes for investors, Basu said that it's important to carefully consider the potential risks and benefits before deciding whether to invest in a fund that charges this type of fee structure.

"It's also important to carefully evaluate the fund manager's track record and investment strategy to ensure that they are well-suited to managing the investment," he added.

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