Lower expense ratios of MFs good for investors

They should be vigilant about the cost of investment in their portfolio and take steps to reduce this

With the Securities and Exchange Board of India (Sebi) constantly asking fund houses to lower mutual fund expenses, investors have been able to bring down the cost of investing substantially.

Reports suggest Sebi is likely to launch another drive to bring down the maximum expense ratio that equity mutual funds can charge from 2.5 per cent to two per cent, and thereafter in phases to 1.5 per cent.

Expense ratios in India appear to be higher in comparison to global practices, but there is a catch. Indian mutual funds have a bundled expense ratio, which includes the fund management fee, administrative costs, and distribution fee. Developed markets like the United States have an unbundled structure, where the expense ratio includes only the management and administrative fees. Clients negotiate the fee they wish to pay to the advisor. “If you compare the total cost investors have to incur to own a fund, India falls somewhere in the middle of the pack,” says Kaustubh Belapurkar, director, Morningstar Investment Advisor India.

Experts say there are many reasons why Sebi wants to lower expense ratios. First, it wants economies of scale to come in. This is in line with the recommendation of the Sumit Bose Committee, which said: “Competition has not reduced costs much below the expense ratio that was fixed when the AUM (assets under management) of the industry was much lower. The regulator should lower the cost caps as AUM rises over time.” Second, industry participants believe Sebi wants it to move from a distributor-led model to an advisory model. “One way to make the distributor-led model unrewarding would be to disincentivise it,” says Deepesh Raghaw, founder, PersonalFinancialPlan, a Sebi registered investment advisor (RIA).

While Sebi’s next move is awaited, investors can take a few steps to lower their cost of fund ownership. Doing so is imperative as returns from equity funds are variable (there are years when returns are negative) while costs remain constant. Also, as markets become more efficient and generating alpha (excess returns of a fund relative to return of a benchmark index) turns more difficult, as is already happening in the large-cap space, investors will have to pay greater attention to cost.

 

When choosing an active equity fund, first pick those that have given high risk-adjusted returns across time horizons, and from among them give preference to those whose expense ratio is average or below. This is what experts do: they give a higher weightage to criteria such as risk-adjusted returns, but also give some weightage to expense ratio. Says Renu Pothen, research head, fundsupermart.com: “In the model that we use to select the best funds for a particular year, expense ratio is given a weightage in both equity and debt categories.”

Expense ratio becomes the primary criteria for fund selection in case of index funds, which generate no alpha. In case of ETFs, investors should factor in both expense ratio and liquidity.   

Those who need advice should approach a Sebi-RIA and then invest in direct plans of equity funds, whose expense ratios are on an average 80 basis points lower than that of regular funds (for diversified equity funds). Raghaw suggests that existing investors who wish to switch to direct plans to lower costs should do so only after a year in the case of equity funds to avoid tax and exit load.