Investors should keep a check on cost in passive, debt funds: Experts

In active funds, you may miss out on potential winners if focus is only on expense ratio

Several fund houses – SBI, HDFC, UTI and Tata – have recently hiked the total expense ratios (TERs) of their Nifty and Sensex-based index funds. Expense ratio is deducted from a fund’s gross return to arrive at its net return, which is what the investor receives.

Given the strong link between cost and return, investors must keep an eye on the fees they pay. At the same time, in some categories, a single-minded focus on cost could lead to the exclusion of funds with the potential to produce high returns.

In index funds, competition drove expense ratios to unsustainably low levels. “Fund houses were probably losing money by charging expense ratios in the range of 5-10 basis points (bps). Raising it to a more sustainable 15-20 bps level is fine,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries. An investor need not switch out of a direct index fund, he says, unless its expense ratio has risen far above 20 bps.

Passive funds 

Cost should play a crucial part in the selection of passive funds (index funds and exchange-traded funds, or ETFs). “Here your primary consideration should be: Which fund can mirror the index at the lowest cost?” says Gautam Kalia, head–investment solutions, Sharekhan by BNP Paribas.

Tracking error should be the primary selection criterion. “It tells you how closely the fund has mirrored its index. Even if a fund is cheaper, don’t go for it if it has failed to track the index closely,” says Kaustubh Belapurkar, director-manager, research, Morningstar Investment Adviser India. If two funds have tracking errors in a similar range, he says, then one can opt for the lower-cost one.

A steep hike in a fund’s expense ratio poses a problem for investors who need to shift. To reduce the tax impact, he must complete one year in an equity fund and three years in a debt fund. “To minimise the chances of fund houses hiking the expense ratio, stick to dominant fund categories. These are Nifty50 funds on the equity side and overnight funds in the debt space. Competition will ensure fund houses avoid high fee hikes in these categories,” says Luthria, who advocates building minimalist portfolios with just a few essential categories.

Actively-managed funds

Investors opt for active funds to earn alpha. “Here, first consider performance (consistency and risk-adjusted return), process and people (quality of the team). After that, bring cost into your fund selection process,” says Belapurkar.

Sometimes, you could miss out on funds with the potential to produce high returns if you make cost your primary selection criterion. Sebi has asset under management (AUM)-based slabs for the expense ratio a fund can charge. As AUM rises, expense ratio must decline. “The largest funds have the lowest cost. But they are also less nimble. They can’t move in and out of stocks easily due to high impact cost. If you want a more dynamically managed fund, you will have to go with a smaller fund, which will have a higher fee,” says Kalia.

Debt funds

Most debt fund categories give long-term average returns in the range of 6-9 per cent. Cost becomes crucial here as high cost eats away a higher percentage of the investor’s return. Give primacy to two criteria—suitability of fund category for your investment horizon and risk appetite, and quality of fund management. Once you get a set of funds based on these filters, select a low-cost fund.

Finally, avoid paying high costs in non-essential categories, like sector and thematic funds, children’s plans, retirement plans, new fund offers, etc.