Investors should use expense ratio as elimination criterion, say experts

Eliminate all those funds from your selection universe where the expense ratio is extremely high

Expense ratios of direct plans of several funds have increased in recent months. In the case of DSP Equity Fund, for instance, the expense ratio has risen from 58 basis points to 1.10 per cent. Other funds like Nippon India Multi-Cap Fund, Nippon India Focused Equity Fund and ICICI Prudential Pharma Healthcare and Diagnostic Fund have also seen increases of 44-57 basis points. Several other funds from fund houses like Franklin Templeton, Axis and SBI have seen smaller increases of 7-14 basis points.

An increase in expense ratio impacts the net return that the investor receives unless the fund manager is able to enhance the gross return, he earns to be able to compensate for the increase in expense ratio. Remember that the fee, once implemented, is bound to be charged, whereas there is no surety that the higher return will be forthcoming.

Let us consider one example. Suppose that an investor initiates a systematic investment plan (SIP) of Rs 10,000 per month in a fund for 15 years. The fund gives a net return of 11.25 per cent. The investor will end up with Rs 46.98 lakh at maturity. Now suppose that the fund's expense ratio goes up by 50 basis point. If the gross return remains the same, its net return will decline from 11.25 per cent to 10.75 per cent. Over the same period, the investor will end up with a maturity value of  Rs 44.82 lakh. In other words, a 50-basis-point hike can cost the customer around Rs 2.16 lakh over a 15-year period.

At a time when actively managed funds are finding it difficult to beat their benchmarks, especially in categories like large-cap funds, should you worry about a hike in the expense ratio of a fund you have invested in? And does it call for any action on your part?
 

According to Vidya Bala, co-founder, Primeinvestor.in, “Investors in actively managed funds should not worry about a 10-15 basis point increase in expense ratio. If the increase is 50-75 basis points, that will have an impact on return over a 7-10-year period.” 

 

According to her, instead of worrying about the rise in expense ratio, investors should focus on the fund's performance, whether the fund manager is consistent in implementing his fund's stated strategy, and whether that strategy fits into the investor’s portfolio. According to her, since returns are net of costs, if the fund is inefficiently priced, that will show up in performance eventually. She says that if you make expense ratio the starting criterion for selecting funds, there is a chance you may miss out on a high-quality actively-managed fund. She further adds that investors who are worried about a fund manager’s ability to generate alpha and thereby justify its higher fee should move to low-cost index funds and exchange-traded funds (ETFs).

Factors other than expense ratios of funds may have a greater impact on one’s portfolio return. Says Gautam Kalia, head–investment solutions, Sharekhan by BNP Paribas: “According to long-term studies, the factor that has the biggest impact on portfolio return is asset allocation,” he says. The key, he says, is to determine your risk appetite and decide whether an 80:20 or 70:30 equity-debt ratio is suitable for you, and then stick to it through thick and thin.

Others experts feel investors should use expense ratio as an elimination criterion. “Expense ratio is critically important. But you cannot use it as a selection criterion. You can’t say that I will choose Fund A over Fund B because the former has a lower expense ratio since you have no control over the expense ratio. Fund houses are free to raise it anytime—within the limits stipulated by the regulator.” According to him, expense ratio can serve investors better as an elimination criterion. If, for instance, they see a sector fund that has an egregiously high expense ratio, they should steer clear of it, says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

In case of debt funds, too, one should apply more stringent criteria. “Since their long-term returns tend to range between 5 and 8 per cent, even a 20-30 basis point increase is sharp in their case,” says Bala. Luthria adds that in debt funds that have a high fee, fund managers tend to take more risks. Moreover, the three-year limit before your capital gains are treated as long-term means that you should exercise even more caution while selecting these funds, since you may have to stick to these funds for a longer period.

When investing in passive funds, give primacy to expense ratio (and tracking error). “It’s a commodity product, so one should be hyper-conscious about costs there,” says Luthria. Also, in such commodity products, competition works in the investor’s favour, so there is less chance of a fund house hiking the expense ratio.

Expense ratios of hybrid funds (barring arbitrage funds) also tend to be on the higher side. That is another category where investors should first think about whether he should invest at all, or whether his needs can be served by investing separately in an equity and a debt fund. If he does decide to invest, he should be wary about the high fee.

Investors should also avoid new equity funds (funds that have been around for less than three years). Not only do these funds lack a track record, their fee also usually tends to be on the higher side because of their smaller AUM size.