An expensive proposition

Charges of mutual fund schemes have risen about 20 per cent in the past year but don't let cost be your sole criterion to select one

Inflation might be trending lower but mutual fund (MF) investors are bearing higher costs. On an average, asset management firms are charging 2.5-2.7 per cent for equity schemes, against 2-2.25 per cent a year or two earlier. In the same period, debt fund expenses have increased from 1.5 per cent to 1.7-1.8 per cent.

When the market is on a roll, it is easy to forget how expensive your MF scheme is. It is when the market starts underperforming that expenses start hurting. Sample this: Rs 1 lakh invested in an equity scheme generating a pre-expense return of 16 per cent a year and charging 3.25 per cent will increase to Rs 3.20 lakh in 10 years. This is Rs 32,744 less than what you would have got if you had invested in a scheme charging 2.25 per cent.

"Expenses could significantly impact returns over a period of more than five years because of the compounding effect," says Dhaval Kapadia, director (investment advisory), Morningstar India.

How did it change?

Expenses have slowly nudged up since September 2012, after the Securities and Exchange Board of India (Sebi) tweaked norms with regard to expenses. Earlier, the total expense ratio (TER), the annual charge deducted from the net asset value of a scheme, was capped at 2.5 per cent. The TER was inclusive of accounting, distributor, custodian, registrar and service tax charges.

While the 2.5 per cent limit was retained under the new norms, fund houses were allowed to charge an additional 30 basis points depending on the percentage of their sales from beyond the top 15, or B15, cities. And, as compensation for ploughing back the exit load into the scheme, fund houses were allowed to charge an additional 20 basis points, too.

Also, service tax was taken outside the ambit of TER. Large fund houses now charge an average of 1.7 per cent as fund management fees. If 14 per cent service tax is levied on the fund management fees, the expenses rise by an additional 22-25 basis points. "In one stroke, the regulator's new norms indirectly raised expenses by about 30 per cent --- from 2.5 per cent to 3.25 per cent," says Manoj Nagpal, chief executive of Outlook Asia Capital.

He adds, globally, fund expenses typically amount to 10 per cent of returns generated. Assuming long-term average returns of 15-18 per cent for Indian equities, the country's equity funds should be charging 1.5-1.8 per cent, he says. Similarly, debt schemes should be charging about one per cent, assuming long-term average returns of about 10 per cent. "Simply put, Indian funds are 70-90 per cent costlier than funds in developed markets," says Nagpal.

Should investors worry?

Higher expenses eat into your net asset value and overall returns. But investors should consider expense ratios in conjunction with the scheme's risk-adjusted returns and track record, as well as the fund house's pedigree and strategy. "If two funds are similar on these parameters, the expense ratio could become a deciding factor in choosing the scheme," says Supreet Bhan, executive director and head of retail sales, JPMorgan AMC.

Kapadia says expense ratios can vary between schemes within the same category and investors should take that into account. "If the average expense of a category is two per cent and your fund is charging you 2.1 or 2.2 per cent, it might be okay. But if the fund is charging 2.7 per cent, it might be better to avoid it," he says.

Some experts say expense ratios have a greater bearing on debt funds. "The ability of fund managers to significantly outperform peers is limited. For example, the difference in returns between the best and the worst AAA-rated paper might be only 10-20 basis points. So, higher expenses could significantly eat into your debt returns," says Feroze Azeez, executive director and head of investment products, Anand Rathi Private Wealth Management.

Azeez adds expense ratios shouldn't be a priority for equity investors because the difference in performance between funds can be huge: "If the fund manager is good and has a track record of generating alpha, you shouldn't mind paying a little extra."

Working around expenses

Vidya Bala, head (MF research), Fundsindia.com, says while selecting a fund, investors should focus on returns rather than expenses, as returns are calculated after accounting for expenses. "If the returns are significantly higher than benchmarks, investors need not worry about the expense ratios. Look for an outperformance of at least five per cent for mid-cap funds and two per cent for large-cap funds," she says. According to Azeez, 20-50 basis points of additional expenses do not matter much if the investment is that of a few lakhs; but will start to pinch considerably in the case of an investment of more than Rs 1 crore.

Expenses wouldn't be a huge burden if investors pick larger schemes. For equity schemes, fund houses could charge 2.5 per cent for the first Rs 100 crore, 2.25 per cent for next Rs 300 crore, two per cent on the next Rs 300 crore and 1.75 per cent on rest of the assets, according to Sebi norms. For debt schemes, the charges are 25 basis points lesser for each slab.

For some savvy investors, opting for direct plans could be a way out. "Higher expenses are prompting high net worth investors to migrate to direct plans. The exodus is not large, but is gaining ground," says Nagpal.

Investors could save about 75 basis points in direct equity plans vis-a-vis regular equity plans. For debt categories, the savings could be five to 10 basis points for liquid funds, 25-30 basis points for short-term bond funds and 50-60 basis points for long-term debt funds.

According to Kapadia, one can explore the possibility of investing in index funds or exchange traded funds in categories such as large-cap funds, where the alpha generated over the benchmark is limited. "Typically, these funds charge 50-75 basis points, which could mean savings of 150-175 basis points over actively managed funds," he says.

Azeez, however, feels this strategy could backfire, as active fund managers have historically outperformed passive funds in India. To prove his point, he says Rs 100 invested on the Nifty on April 1, 1996, would have grown to Rs 700, while the same amount invested in 10 funds (Rs 10 in each fund) would have increased to Rs 2,800, a 2,200 per cent gain over the passive strategy. "Don't be penny-wise and pound-foolish," he cautions.