With benchmarks becoming harder to beat, avoid very high-cost funds

The Securities and Exchange Board of India (Sebi), through a circular dated November 5, mandated that asset management companies must disclose expense ratios for direct and regular plans separately in their half-yearly statements.

 

“Sebi is looking to make disclosures regarding expenses of regular and direct plans uniform and transparent for investors,” says Kaustubh Belapurkar, director–manager research, Morningstar Investment Research India.

 

Direct or regular?

 

Direct plans are ideal for do-it-yourself (DIY) investors who can make their own investment decisions, from asset allocation to fund selection.

 

For new investors needing guidance, there are two options: working with a distributor who earns commissions from regular plans, or with a registered investment advisor (RIA) who charges a fee and recommends direct plans.

 

 

“A new investor making a small investment may find an RIA’s fee steep. For such an investor, buying regular plans through a distributor may be more cost-efficient. Once their portfolio grows, they may move to an RIA. This is assuming both the RIA and the distributor are equally competent,” says Deepesh Raghaw, a Sebi-registered investment advisor.

 

Passive funds 

 

Cost is crucial in passive funds. “Here, a lower expense ratio is beneficial as it reduces the tracking error and tracking difference,” says Belapurkar.

 

If there are two Nifty index funds, one with an expense ratio of 50 basis points and another with 10 basis points, the latter has a 40-basis-point head start.

 

However, the tracking difference is what matters ultimately. For instance, Fund A with an expense ratio of 10 basis points may have a tracking difference of 100 basis points, while Fund B with an expense ratio of 50 basis points may have a tracking difference of 80 basis points. “In this case, the latter fund is the better choice. Ultimately, the investor’s return is determined by the tracking difference,” says Raghaw.

 

Two other factors must be considered. “The fund’s assets under management (AUM) must not be too small, and exchange-traded funds (ETFs) must have liquidity on the exchanges,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

 

Active funds 

 

Active funds must generate added returns that offset their higher expense ratios compared to passive funds.

 

“In active funds, besides the expense ratio, look at risk-adjusted return ratios, such as Sharpe, Treynor, and information ratios. Consider the fund manager’s experience, track record, investment style, and the fund’s concentration risk. Consider long-term consistency, better gauged through rolling returns rather than trailing returns,” says Dhawan.

 

According to Belapurkar, qualitative factors, like the investment team, investment process, and parent organisation, must be assessed while evaluating a fund’s potential to outperform. “Still, lower-cost funds generally have a greater chance of surviving and outperforming their more expensive peers,” he says.

 

Debt funds 

 

In active equity funds, a high fee may be justified if the manager generates alpha. “In debt funds, where the potential for alpha is limited, be cautious about high costs,” says Raghaw.

 

Dhawan adds that investors should also consider the type of risk the debt fund takes— credit or duration. Investors should match their investment horizon with the fund’s portfolio duration.

 

Finally, avoid extremes. By and large, avoid very high-cost funds. “Even in the case of active funds, avoid paying a very high fee since markets are hard to beat over the long run,” says Raghaw.

 

At the same time, as Dhawan suggests, base your decisions on a comprehensive set of criteria rather than simply selecting the lowest-cost option.

 

Portfolio construction: Go top-down

 

·       Portfolio construction begins with asset allocation, which depends on risk appetite and investment horizon

 

·       Diversify the equity portion of portfolio by geography, market caps and styles

 

·       Decide sub-asset allocation: on the equity side, domestic and international; large, mid, small-cap funds on the domestic side

 

·       On the debt side, sub-allocate based on credit risk and duration

 

·       Evaluate if you can deal with the volatility in each product category

 

·       Decide whether to take exposure to an active or passive fund in each category

 

·       Finally, get down to choosing a fund in each category