Other factors remaining the same, a higher expense ratio means lower returns for investors
Dec 4, 2020 / 09:54 AM IST
Mutual funds incur various costs to manage your money. These include fund management, custodian, registrar & transfer agent charges, marketing expenses, commissions payable and other recurring costs. The costs under different heads is aggregated into a single figure and is charged to the scheme as a percentage of the assets managed. This is termed as the expense ratio (or total expense ratio – TER) of the scheme.
How much are MFs allowed to charge?
While the equity funds can charge up to 2.25 percent, non-equity schemes can charge up to 2 percent as base expense ratio. This expense ratio is to be brought down as assets under management (AUM) increase, according to the slabs prescribed by the Securities Exchange Board of India (SEBI). Exchange traded funds investing in indices and gold cannot kevy more than 1 percent as base TER. Fund of funds cannot charge more than 2.25 percent, including the expense ratio of the underlying equity schemes. In case of fund of funds investing in bond funds, the TER cannot exceed 2 percent including the expense ratio of the underlying schemes. Funds are also allowed to charge an additional 30 basis points towards expenses if they get inflows from beyond the top 30 cities in India. Goods and services tax is charged over the base expense ratio.
Other factors remaining the same, a higher expense ratio means lower returns for investors.
Expense ratio is dynamic
TER is a number expressed as a percent of a daily assets of the scheme. It is made available on the website of the mutual fund and also in the fact sheet. Fund houses can change the expense ratio periodically. Many a time, fund houses offer low expense ratio to attract investors when the scheme is launched and the same is gradually hiked within the limit prescribed by the SEBI after a track record is established.
When expense ratio is increased, the same needs to be communicated to investors at least three days prior to such a change, by sending an email or SMS.
Charges vary: Active vs Passive and Direct vs Regular
Regular plans of the mutual fund schemes are sold by distributors and the TER of these schemes factors in the commission payable along with other expenses. The TER of a direct scheme does not have this commission component and hence charges lower TER compared to a regular plan. If you are a ‘do it yourself investor’ and can choose the right schemes, then you can consider investing in direct plans.
Actively managed funds charge more than passive schemes. Exchange traded funds (ETF) mirroring the widely followed index – Nifty 50 – charge as low as five basis points.
Investors, however, should not paint all passively managed products with same colour. ETFs tracking thematic indices may charge more. For example, Nippon India ETF Shariah BeES and Nippon India ETF Infra BeES charge 1.03 and 1.09 per cent, respectively, according to Value Research.
“The inability of many actively managed funds to beat the benchmark indices have already made many investors consider passive funds. In a low expected return environment it is all the more important that investors build a combination of active and passive products to keep a tab on their expenses and boost returns,” says Vishal Dhawan, founder and Chief Financial Planner, Plan Ahead Wealth Advisors. “Nowadays, you have passively managed low-cost products in bond and equity segments,” he adds.
Returns after expense matter
A few years ago, when the investors were chasing high yield credit risk funds, they ignored the high expenses. It resulted in almost similar returns as compared to other low yield high quality debt funds such as corporate bond funds and banking & PSU bond funds, which charged much less.
For example, if a bond fund has a portfolio yield of 5.5 percent and expense ratio stands at 75 basis points, then the expected return stands at (5.5 minus 0.75) 4.75 percent.
Fund houses have launched multi asset funds and other hybrid funds that invest in multiple asset classes. In such cases, the TER of the scheme needs to be checked in the context of expected returns. Debt oriented hybrid funds have become unattractive given their high expenses and low expected returns.
When an investor knows the right asset allocation for him and has the discipline to stick to it, he should do so on his own by selecting a right mix of bond and equity schemes. This helps to save on expenses, and boost returns,” says Rupesh Bhansali, head of mutual funds, GEPL Capital.
Expense ratio and investment decisions
Though the expense ratio of a mutual fund scheme is important, it cannot be sole criterion for choosing an investment. “What if you are on a fund charging low expense ratio and it doesn’t deliver the desired outcome,” asks Ravi Kumar TV, founder of Gaining Ground Investment Services. “Though the last few years have been challenging for many actively managed funds, they are expected to come back in the current environment and investors will move back to actively managed funds soon. In addition to expense ratio, investors need to consider other costs such as taxes,” he adds.
While assessing passively managed funds, the expense ratio plays a crucial role. In debt funds, check for the fund manager’s ability to manage both credit and interest rate risks, among other factors.