Why did SEBI impose penalties on DSP Asset Management Company?

In a rather surprising move, SEBI imposed a penalty of Rs. 1 lakh on DSP Asset Management Company and the Trustees for absorbing a major chunk of the total expense ratio (TER) of its recently launched DSP Nifty 50 ETF scheme. The question is whether there is anything wrong in the AMC absorbing the costs in the AMC books. According to SEBI, this is in violation of a 2018 circular which stipulates that all scheme related expenses should be only billed to the scheme in the form of TER. They cannot be borne by the AMC, as it would create an ecosystem where mutual funds undercut each other and in the process the larger AMCs with larger revenue books and AUM would be in a more domineering position.

That is the kind of situation that SEBI wants to avoid. Just to recap, back in 2018, SEBI had issued a circular mandating that fund houses must necessarily charge all the mutual fund scheme-related expenses to the schemes only. No type of facilitation by the AMC would be permitted. This is a first of its kind case where the AMC has been penalized for absorbing the TER into its own AMC books. The penalties may be small, but it kind of makes the point quite clear that the regulator would not be open to facilitation of any kind. They want all scheme related expenses to be only billed to the scheme, with just a 2 bps leeway.

What exactly are the facts of the DSP case here? The case pertains to DSP Nifty 50 ETF, where the total expense ratio (TER) was 0.16% or 16 basis points. Since the time the fund was launched last year in December 2021, DSP AMC has only charged 0.07% or 7 basis points to the scheme as its total expense ratio or TER. The balance 0.09% or 9 basis points have been absorbed by DSP Investment Managers. That is what SEBI has objected to. Extant rules modified in 2019 allow the AMC to absorb up to 2 basis points of cost on behalf of the fund, but not 9 basis points as DSP AMC has done in this case. Going by the spirit of the 2018 circular, the entire expense ratio has to be charged to the particular scheme only.

However, DSP Investment Managers has objected to the penalty on the grounds that this was done only to benefit the unit holders and cannot be held against them. For instance, when the DSP Index ETF was launched in December 2021, it collected Rs. 11.81 crore and by March 2022 when the fiscal year ended, the AUM had just moved up to Rs. 22.59 crore. DSP has contended that the costs of running even a passive scheme could push the total costs up and make the scheme unattractive when compared to peers. DSP was of the view that this was only done as a temporary measure till the time the AUM of the fund acquired scale after which the mutual fund would adhere to the 2018 circular, in letter and spirit.

What DSP says is the practical problem. Currently, SEBI permits passive funds like ETFs and index funds a maximum total expense ratio (TER) of 1%. But that is not practical if one looks at the competitive scenario. That is why most of the passive funds charge lower than that. Out of the 33 large-cap ETFs in the market, around 13 ETFs charge up to 7 bps, which is what DSP had charged on the ETF. Actually, the index funds charge a bit higher in the range of around 0.30%, but ETFs generally keep it really low. DSP is of the view that in order to scale up AUM, it needed to keep its costs low, at least till the time the AUM built up scale and was able to absorb higher costs without pushing higher TER to the end customer.

However, SEBI is not buying this argument. Firstly, it is contrary to the SEBI 2018 circular and any laxity in this case would make it a practice. In fact, absorbing charges was rampant in the mutual fund industry among the AMCs. The circular was an attempt to stop this escalation of expenses. In addition, SEBI had permitted leeway to the tune of 2 basis points and did not want to encourage any leeway beyond that. SEBI also objected to the fact that this absorption was not disclosed in the offer document. Ironically, this information was voluntarily disclosed by DSP AMC to SEBI as part of its quarterly test report.

However, SEBI has now contended that these reports were meant for fund houses and trustees to report any divergence from SEBI rules. The very fact that the fund house and trustees mentioned the excess TER absorption as part of these reports, clearly underlined the fact that that they knew of the ramifications. For now, the last word may not have been said on this subject.