Investing in mutual funds? More cuts in expense ratio may not help you

If the entire financial sector does not move to a lower-cost regime, it will only lead to more mis-selling

Retail investors, while investing in mutual funds, should concentrate on three things: 1) Is the scheme they are investing in a long-term performer? That is, has the scheme been consistent over one bear and one bull cycle, at least? 2) What is the mandate for the scheme and does it suit your risk profile? For example, someone may want to sell you a sector fund that is performing well. But if you are investing for the first time, there is no point in buying such schemes because the fortunes of a sector fund can change much faster than that of a well-diversified scheme. 3) Cost of the scheme.  

The Securities and Exchange Board of India (Sebi), on its part, has been consistently targeting the ‘cost’ factor, perhaps a bit too aggressively.

Newspaper reports suggest that after asking fund houses to link their schemes’ performance to total returns (returns + dividend income), now it is thinking of linking expenses to funds’ performance.
 

Hemant Rustagi, chief executive officer, Wiseinvest Advisors said, “Linking funds’ performance to total returns is a good move because it will help investors to understand by how much the fund manager has actually outperformed.”

However, most believe that linking the expense ratio to performance could be a bad move. “The fund manager may have taken calls, which will lead to short-term under/steady performance. And if the expense paid to the scheme is lower because of that, how does one compensate the fund manager when he outperforms significantly in a single year,” asks a fund manager. And such moves would force fund managers to concentrate on steady stocks or stocks ‘in vogue’ instead of picking value stocks that will deliver over time. “Also, if expenses have to be performance linked then expenses have to be divided into two parts – one basic fee for simply managing money and other for out/underperformance," said a CEO of a fund house.

Of course, there is no denying the benefits of expense cuts. If an investor puts a lumpsum amount of Rs 100,000 in a regular plan (assuming expense ratio of 2.39 per cent) and the gross return of the scheme is considered at 14 per cent annually, a cut in expense by 50 basis points would lead to improving returns by Rs 3,914 over five years. And this number would be significantly higher by 84,129 over a 20-year period.

But there are larger consequences of cutting costs, say investment advisors. According to them, anyway, the number of mutual fund advisors is dwindling because increasingly it is becoming difficult to earn money in this profession. “Also Sebi’s latest proposal of completely separating investment advice and distribution, if implemented, will make things worse,” said a fund manager.

 Recently, Sebi floated a discussion paper where it has proposed that ‘banks, non-banking financial companies, corporates, limited liability partnerships and firms providing distribution services shall not provide investment advice in financial products, either directly or through holding or subsidiary company’ would mean that banks' relationship managers will not be allowed to give advice to customers on mutual funds. And this would hurt the industry quite badly as these segments contribute 40 per cent of the inflows to mutual funds.

Of course, no one will disagree that Sebi has the right intentions, but the entire financial sector should move towards lower costs so that there is no regulatory arbitrage. At present, retail investors are being happily mis-sold insurance products, at the cost of mutual funds. And bringing down expenses could mean more mis-selling.