High expense ratio erodes mutual funds' net return, so monitor cost

If your distributor suggests moving from a low- to a high-cost fund, question the rationale of the move

The Securities and Exchange Board of India (Sebi) has come out with a consultation paper recommends changes to the way the total expense ratio (TER) of mutual funds is calculated and charged. The paper also seeks to curb malpractices linked to expense ratios.

Investors, on their part, need to be cognizant of the role expense ratio should play in fund selection, and remain vigilant against malpractices.  

High cost affects return 

When choosing a fund, pay attention to the expense ratio that eats into the gross returns generated by the fund. According to Kaustubh Belapurkar, director-manager research at Morningstar Investment Advisor, “The net return the investor gets is the gross return minus the expense ratio. So, the lower the expense ratio, the better the return for the investor.”

When a fund’s expense ratio depends on the size of its asset under management (AUM), distributors at times push non-vigilant clients into smaller-sized funds, including the riskier thematic and sectoral offerings, so that they can earn a higher commission. “Investors need to be vigilant about overpaying in such an environment,” says Avinash Luthria, a Sebi-registered investment advisor (RIA) and founder, Fiduciaries.

Experts, however, advise against making expense ratio the primary criterion for fund selection. Says Belapurkar: “A fund can’t be selected just because it is inexpensive. Evaluate the funds in a category on a variety of parameters. Then, if all else is equal, opt for the fund with a lower expense ratio.”

Typically, the larger asset management companies (AMCs), whose funds have larger AUMs, have lower expense ratios. Says Vidya Bala, co-founder, Primeinvestor: “If you simply go by expense ratio, you will always end up with a large AMC. But there could be smaller AMCs that are delivering good performance. You will miss out on those. Consistency in performance should come first and then the cost.”

Bala suggests looking at the difference in expense ratio between the regular plan and the direct plan. “If the difference is significant, rather than forgoing the fund (if its performance is good), invest in its direct plan,” says Bala.

Keep a tight lid on costs

In certain categories, funds with high expense ratios need to be especially avoided. Says Bala: “In the case of debt funds, returns are in single digits. Even a slightly higher expense ratio can significantly affect your compounded return over the years.” 

In passive funds, where the fund mirrors an index’s performance, one should again be vigilant about cost. Bala highlights three important factors to consider. “First, ensure that the index fits into your portfolio and is performing well. Second, check if the fund has a high tracking error, which indicates the fund manager is doing a poor job of tracking the index. And third, examine the fund’s expense ratio.”

Adds Belapurkar: “When tracking errors of two funds are similar, go for the fund with the lower expense ratio.”

The hybrid category, where many funds have a high expense ratio, is one where the investor needs to be watchful.

Fund houses sometimes increase the expense ratio of a fund. One category where this could happen is passive funds. “While I would like to prescribe a fund based on the Nifty 500 index to my clients, I don’t. I stick to Nifty 50 based funds. This is to guard against the risk of fund houses hiking the expense ratio in the future. There is greater certainty they won’t do so in a Nifty 50 based fund due to the high competition in this category,” says Luthria.

According to Belapurkar, if the hike is marginal and the fund is suitable for your portfolio, avoid exiting as doing so would mean incurring capital gain tax. “However, if the change is significant and there is a better and cheaper alternative available, you may switch,” he says.

Instead of reacting impulsively, monitor performance. Says Bala: “If performance declines after the increase in expense ratio, and the fund significantly underperforms its index or peers, it indicates that cost has played a role.” In that case, switch.

At times, distributors switch investors from a fund with a lower total expense ratio (TER) to one with a higher TER, often a new fund offer (NFO). This practice has caught Sebi’s attention. According to Sebi’s consultation paper, 27 per cent of the flows into NFOs come from such switching from existing funds. To discourage this practice, Sebi has proposed that if a distributor switches a customer from a lower TER scheme to a higher TER scheme, his commission will be based on the lower TER.

Until this is implemented, investors need to watch out for their own interests. Belapurkar emphasises that investors who work with distributors should inquire about the merits of a switch. “Ask your distributor how the switch adds value to your portfolio,” he says. He adds that investing in an NFO is acceptable only if it brings unique value to the portfolio that an existing fund can’t provide. In most cases, investors are better off sticking with established funds that have a proven track record.

Direct or regular plan?

According to Sebi’s consultation paper, direct plans, which have lower expense ratios, have a higher likelihood of outperforming the index. So, should investors prefer these plans over regular ones? Says Belapurkar: “Opt for the direct route if you are capable of selecting quality funds yourself.” He cautions that if you end up choosing the wrong funds, the 50-100 basis points saved through the direct plan route may not be worthwhile.

The Sebi paper sheds light on the malpractice of churning customers that distributors engage in. To avoid falling prey to it, investors should consider the direct route. Says Bala: “If you can afford the fee of a Sebi-registered investment advisor (RIA), that is a good option. Alternatively, there are many platforms that provide research assistance to help you select direct plans for your portfolio.” Another option, she says, is to opt for simple passive funds, which make fund selection easy.

Finally, remember that asset allocation plays a bigger role in determining an investor’s portfolio return than the selection of individual funds. Therefore, investors should first determine an appropriate allocation to different asset classes (equity, debt, gold, etc.), then decide on the suitable mix of sub-asset classes (say, large-, mid-, and small-cap funds within equities), and finally focus on selecting the right funds. After assessing funds based on return, risk, and other parameters, give preference to the less expensive option among the shortlisted ones.

What Sebi’s consultation paper says

Asset Management Companies (AMCs) need to share the benefits of economies of scale with customers

Total expense ratio (TER) for each category will depend on the AMC’s asset under management (AUM), not scheme AUM

Sebi proposes to change the TER slabs

It has also proposed performance-linked TERs   

Several costs, which fund houses were allowed to charge over and above the base TER, would be subsumed within this figure

If distributors switch customers from lower to higher TER fund, the commission they are paid will be linked to the lower TER