Is expense ratio the most important criteria while choosing MF schemes?

The Securities and Exchange Board of India (Sebi) has been on a relentless drive to cut the cost of investment in mutual funds. On Wednesday, the market regulator effected a further 15 basis point cut on additional expenses. For long-term investors in mutual funds schemes, every cost saving does mean higher returns. But should the expense ratio be the most important consideration while choosing mutual fund schemes?

In a certain category, cost does matter. That is, the exchange-traded fund segment (ETF). So, if an ETF that clones the Nifty 50 is charging 0.07 per cent as expense vis-a- vis another similar scheme’s cost of 0.05 per cent, clearly the latter should be chosen. Of course, even though these schemes should be passively managed and simply clone the underlying index, many fund managers in India do some active management to improve returns. But better performance due to active management in ETFs should not be the deciding factor, and investors should not pay higher cost for this, say mutual fund experts. 

But things do change when one wishes to invest in other categories of mutual funds. There are many schemes that charge over two per cent expense ratio, some even more than three per cent, in actively-managed schemes like large-cap, mid-cap, and small-cap funds. The situation is much trickier here. The fund managers in these schemes play an active role in ensuring that investors earn good returns. Most try, and succeed, in outperforming their benchmark indices. For example, Aditya Birla SunLife Top 100 Fund charges 2.31 per cent expense. In the past one year, the scheme has returned 9.88 per cent as against 12.59 per cent return of its benchmark Nifty 50. But over a three-year period, it has returned 9.31 per cent – significantly higher than 6.87 per cent given by the Nifty 50.

Says Hemant Rustagi, chief executive officer, WiseInvest Investment Advisors: “Sebi’s drive towards further reduction in expense ratio is a good move. However, a very aggressive cut may also hamper the industry’s growth because as in every business, existing customers pay for the acquisition of new customers. And a larger customer base will ensure that the industry remains stable.”

The cost-conscious investor, at present, has another option – direct plans of same schemes. If we take the same Aditya Birla SunLife Top 100 scheme, the direct plan option would have improved the investor's returns further – 11.24 per cent in one year and 10.54 per cent in three years. The expense ratio for the direct plan is just 1.09 per cent. The average difference in expense ratios between a regular and direct plan is a good 100-120 basis points. But in order to go direct, you need to do your own research and select the right scheme. This isn’t exactly easy due to the large number of schemes from mutual fund houses. 

The market regulator, on its part, has been proposing several changes to ensure that the mutual fund industry becomes more transparent. It wants distributors giving advice to be separated from sellers of schemes. For investors, the approach should be simple. If they wish to go direct, select schemes with a long track record (at least 10 years) so that they know how it has performed during bull and bear markets. For those who need hand holding, spend the 100-120 basis points and get advice on the right schemes that suit you. Don’t land up buying a scheme with low expense, but lower returns.