Mutual funds get costlier

Charges of many schemes have gone up by a good 50-75 bps. This will hurt returns of investors significantly over the long run

An expense ratio of 3.25 per cent sounds small, especially when the stock market is hitting a new high almost every day. But it impacts returns substantially over the long term. Consequently, financial planner Gaurav Mashruwala says one should look carefully at expense before investing in a scheme.

"Expense ratio is like the inflation rate. Like inflation impacts the real return of investors, if the expense ratio is high, the returns will fall significantly and pinch over the long term."

What it means
It means a serious loss in money. For example, you invest Rs 1 lakh in an exchange-traded fund charging 20 basis points (bps) more vis-a-vis a diversified equity fund charging three per cent in annual fees. Assuming a return of 15 per cent compounded over a 15-year period, the return from the ETF would be Rs 7.5 lakh. The return from the equity diversified fund would be Rs 5.2 lakh. A huge Rs 2.3 lakh difference.

Even if the return is 10 per cent annually, for expenses of three per cent, 2.5 per cent and 2 per cent, the returns over 15 years are Rs 2.5 lakh, Rs 2.8 lakh and Rs 3.1 lakh - a substantial loss to the long-term investor.

Says Dhirendra Kumar, chief executive officer (CEO), Value Research: "The March numbers released by fund companies reveal that equity and hybrid funds (which are what retail investors invest in) now charge an average of 2.42 per cent per annum of assets managed by them. A year earlier, this number was 2.06 per cent. That's an increase of 17.5 per cent in the charges."

And, even debt funds and index funds have high charges. For example, several schemes charge upwards of 2.5 per cent in debt schemes. Says Sundeep Sikka, CEO of Reliance Mutual Fund: "Higher expense ratio will always impact returns. The fund manager is always under pressure to deliver higher returns, to show good performance amid his peers."

Expenses

In simple terms, expense ratio is the fee a fund house charges to operate a scheme. The cost is charged to its assets. While the expense is calculated periodically, it is charged daily on the net asset value (NAV). This annual recurring expenses are disclosed every March and September and is shown as a percentage of the fund's average weekly net assets. The components of the expense are the fund management fee, agent commissions, registrar fees, and selling and promotion costs.

According to guidelines of the Securities and Exchange Board of India (Sebi), for equity schemes, fund houses can charge 2.5 per cent for the first Rs 100 crore, 2.25 per cent for next Rs 300 crore, 2 per cent on the next Rs 300 crore and 1.75 per cent on rest of the assets. For debt, the slabs are 25 bps less. For first Rs 100 crore, the expense ratio can be 2.25 per cent and so on.

From August 2012, the rules changed substantially. To increase participation from smaller cities, Sebi also allowed MFs to charge 30 bps more for raising money from beyond the top 15 cities. The market regulator had said: "Asset management companies (AMCs) would be able to charge 30 bps if the new inflows from these cities/towns are up to 30 per cent of the total inflow. In case the inflow is less, the proportionate amount would be allowed as additional TER (total expense ratio)."

Another 20 bps was allowed to be charged as TER in lieu of transferring the entire exit load to the scheme. A number of fund houses, in recent years, have started charging an exit load to investors exiting the scheme in less than one year or two years. Earlier, the exit load used to go into the fund house's balance sheet. After the Sebi guidelines, investors stand to benefit as the exit load would be ploughed back into the scheme, thereby improving the NAVs.

Even the burden of service tax was put on the investor. That is, the AMC was allowed to charge the service tax of 12.36 per cent on the fund management fees to the investor. Earlier, the fund house paid the service tax. The logic was, since the service was being given to the investor, he/she should bear the tax. If the fund management fee is 1.25 per cent, the impact of the service tax is 15 bps. In other words, in one sweeping measure, the expenses for investors were increased by 65-90 bps and some fund houses seem to be using much of the new limit.

What's gone wrong?
Several things. By removing the sub-limit on expenses, things have been made opaque. Earlier, there was a sub-limit on fund management fees of 1.25 per cent. Now, a fund house can charge the entire 2 or 2.5 per cent as fund management fee. The service tax will go up proportionately.

More important, what is hurting existing investors is the allowance given to fund houses to charge an extra 30 bps for raising 30 per cent of the incremental assets from beyond the B-15 cities/towns. Take an example of an existing scheme with a corpus of Rs 100 crore before the guidelines. After this, it raised an incremental Rs 1 lakh from investors. If it raised Rs 30,000 (of the incremental Rs 1 lakh) from a city beyond B-15, it would be allowed to charge 30 bps more for the entire scheme. In other words, by raising only Rs 30,000 more, the fund house was allowed to charge all the investors an additional 30 bps or slightly over Rs 30 lakh. Says a CEO of a leading fund house: "By allowing this, existing investors in fund houses are being burdened for no fault."

Solutions
One answer can be to go only for big schemes of at least Rs 1,000 crore. Since the expense will come down as the scheme size increases, the burden on the investor will be much less.

Another solution is to invest through a direct plan, in which the fund house does not charge you for distribution expenses. The good news is that the average cost of a direct plan of each equity and hybrid fund is 24 per cent less than the older expense, according to data from Value Research. But as there is no longer a cap on any particular expense, one does not really know how much cost saving will happen in this.

One can also use index funds. However, many funds still continue to charge 1-1.5 per cent on these schemes. Since there is little fund management skills that need to be involved here, as the scheme mirrors the index it is representing, fund houses can do with charging less.