Is your mutual fund too expensive? Avoid paying above-average fees

Investors should avoid paying above-average fees in case of debt funds and large-cap equity funds

At the Business Standard Fund Café 2018, U K Sinha, former chairman of the Securities and Exchange Board of India (Sebi), said that the mutual fund industry in India is one of the most expensive globally and it must bring down the cost of investing. With the industry’s assets under management (AUM) going up, it is expected to come under increasing pressure to pass on the benefits of scale to investors. Also, as the markets become more efficient and the amount of alpha (outperformance) that fund managers are able to generate reduces, the need to reduce the expense ratios of active funds will gather greater urgency.   

Are India’s expense ratios too high? Currently, a debate is going on within the industry regarding whether the expense ratios charged by Indian mutual funds is too high. Morningstar, the rating agency, had come out with its Global Fund Investor Experience Study 2017, which had compared the Indian mutual fund industry with those of 24 other countries on various parameters. India scored average overall, and average on regulation and taxation. It ranked top on disclosure norms. On fees and expenses, however, it scored below average. According to Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India, “We have compared different geographies based on the expense ratio that the investor actually pays.” Morningstar has used the expense ratio of regular funds. Remember that only 12 per cent of equity fund investors in India use direct plans. Belapurkar clarifies that the report does not say that expense ratios in India need to be lowered right away. “The number is understandably high because it is a developing market where there are distribution costs involved to expand the market,” he says.

Moningstar’s conclusion regarding India having a high cost structure has been contested by the Foundation of Independent Financial Advisors (FIFA). It has come out with its own report which, in fact, ranks India as the third least-cost destination. 

To comprehend this debate, one needs to understand that some countries have a bundled fee structure while others have an unbundled one. If you invest in a regular plan in India, you are participating in a bundled fee structure, which includes both the management fee and the distribution commission. Many countries have moved to an unbundled fee structure, where the expense ratio consists of only the fund management fee. Other elements like distribution/advisory fee and platform fee (for purchase and sale of funds) are paid separately by the investor. 

According to Dhruv Mehta, chairman, FIFA, “You can’t compare India’s bundled fee structure with the unbundled fee structure of other nations. If you have a cost structure that includes both fund management fee and distribution cost, it will obviously be higher compared to the cost in a country that includes only the fund management fee.”

To correct this anomaly, FIFA has made adjustments for advisory fees, platform fees, front load charges, and GST/VAT charges to the expense ratios of other countries to arrive at a number for the total expenses that investors abroad bear. After making these adjustments, India’s ranking rises to third least expensive. While the exact quantum of adjustments FIFA has made to the expense ratios of other countries can be disputed, the logic of making such adjustments cannot be denied. As Jimmy Patel, managing director and chief executive officer, Quantum Mutual Fund, says: “When you compare India’s total expense ratios with those prevailing worldwide, it has to be an apple-to-apple comparison. The components of total expense ratio that are compared have to be the same.”

Match falling alpha with lower fees: So far, investors in India have not paid much attention to expense ratios, the reason being that so long as the returns are good, they are not bothered about whether they are paying 2.5 per cent or 1.5 per cent. However, as Patel says: “A high expense ratio ultimately eats into the investor’s returns.”     

According to Belapurkar, when choosing a fund, investors should still pay greater heed to the sustainability of alpha and the quality of the fund management team (the investment processes they follow, etc), since the returns you see are after deducting expenses. He, too, however, adds that investors need to keep an eye on expense ratio because alpha may shrink in future. This has already happened in the large-cap space. When this happens, funds with lower expense ratios will find it easier to beat their benchmarks. Investors, too, will gravitate towards those funds. Belapurkar believes that the industry should proactively reduce expense ratios, as Edelweiss Mutual Fund has done in the case of its large-cap fund.

Be doubly careful in debt funds: In debt funds, returns don’t usually exceed single digit, so paying a high expense ratio can be a costly mistake. Patel warns that some debt funds may invest in higher risk paper, generate higher returns, and charge a higher expense ratio. The investor could lose money in such funds if one of the lower-rated  papers defaults. “Keep an eye on all three things in debt funds—return, expense ratio, and portfolio quality,” he says.

Investors can also lower the expense ratio they pay by investing in direct funds. However, they should ensure they select the right funds, or get the right advice. While they may save 100 basis points or more by going direct, they could lose 200-400 basis points on the returns they could have earned from a good fund. Finally, those going direct also need to be cautious that they don’t overpay for other components like platform fee and advisory fee.