Expert explains why you should avoid unnecessary churning of funds

With new expense ratio slabs coming into force, do not shift from a bigger to a smaller fund without good reason

The Securities and Exchange Board of India (Sebi) had in September 2018 announced new total expense ratio (TER) slabs. These new rates were implemented from April 1, 2019. While retail investors will benefit from cost reduction, they should watch out for unwarranted  churning 

by agents.   

Passing on benefits of scale: The old TER slabs were introduced in 1996. Since then there has been a humongous increase in the industry’s assets under management (AUM). Between February 2014 and February 2019, industry AUM has grown from Rs 9.20 lakh crore to 24.30 lakh crore , a compounded annual growth of 21.44 per cent. “The earlier slabs were too small — 0-100 crore, 100-400 crore, 400-700 crore, and then a single rate beyond Rs 700 crore. They were not in line with what fund sizes have become, with many funds crossing the Rs 10,000 crore mark,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.    

Moreover, Sebi had become convinced that fund houses had not passed on the benefits of economies of scale to investors. A study conducted by it found that in 72 per cent of equity schemes (regular plans), the expenses charged were either equal to, or up to 0.25 percentage points lower than the maximum permitted limit for base TER. In balanced schemes, the number stood at 87 per cent. In debt funds, on the other hand, around 75 per cent of schemes charged base TERs that were at least one percentage point lower than the maximum limits. Sebi concluded that the benefit of scale had been passed in case of debt schemes, where the investors are predominantly institutional, but not in case of equity and balanced funds, where investors are primarily retail.    

Larger equity funds to be affected more: The maximum base TER that fund houses can charge has come down from 2.50 to 2.25 per cent in equity funds. “The reduction in TER will be more pronounced in larger funds of above Rs 2,000 crore,” says Belpaurkar. This is because the maximum permissible limits have come down primarily for the higher slabs (see table). There could be as much as a 40-basis-point difference in the maximum permissible TER of a Rs 2,000 crore fund versus a Rs 20,000 crore fund. The impact is likely to be less pronounced in debt funds where many funds were already charging much below the maximum permissible limits. 

Expense ratio becoming increasingly important: All investors will benefit from the new TER slabs. “The change will result in reduction of TERs across mutual fund schemes and should straightaway add to the annual returns in clients’ portfolios,” says Aashish P. Somaiyaa, managing director and CEO, Motilal Oswal AMC. 

In recent years, outperformance by equity funds has been declining, especially in the large-cap space. With alpha generation becoming difficult, expense ratio becomes crucial. “If the expense ratio is low, there is greater transmission of returns to investors,” says Belapurkar. Some fund houses, like Edelweiss, have reduced the expense ratios of their large-cap funds. Investors should try to avoid funds whose expense ratios are higher than the category average in this space. In the mid- and small-cap segments, where the scope for generating alpha is greater, investors can be less stringent about expense ratio, especially if a fund is a consistent outperformer. “If a fund has displayed an ability to generate alpha, you may opt for it even if it charges a marginally higher expense ratio than others,” says A. Balasubramanian, chief executive officer, Aditya Birla Sun Life AMC. He suggests that investors may make some allocation to low-cost ETFs in the large-cap space to benefit from their low expense ratios. Direct plans are another low-cost option.

Many experts say that while expense ratio is important, investors should also pay heed to other factors. “Factors like the pedigree of the fund manager and the sponsor, how true-to-label the fund remains, and whether the team follows a process-driven investment approach also need to be looked into,” says Jimmy Patel, managing director and chief executive officer, Quantum Mutual Fund. Adds Somaiyaa: “If you are in a performing fund and it is right for your requirements, then, like to like, having a lower TER will add to your bottomline. But if you pick a fund for its lower TER and end up with a lemon, you will be much worse off than just the difference in TERs.” 

In debt funds, going with a fund having a low expense ratio is critical. Skilled equity fund managers can potentially generate an alpha of, say, 5-6 percentage points. This is simply not possible in debt funds, where the margin of outperformance tends to be wafer thin. Balasubramanian suggests favouring larger-sized funds on the debt side.

Avoid unwarranted churn: With expense ratios coming down in larger funds, the hit to earnings is likely to be shared equally by AMCs and distributors. A 40-basis-point reduction means the distributor may take a 20-basis-point hit. This has stoked fears that some distributors may try to churn investors from larger funds to smaller ones. “A distributor should churn the customer only as part of his overall asset allocation strategy, or to generate alpha in the portfolio,” says Balasubramanian. If he does not provide a sound reason, refuse to go along with such a suggestion.