Every business involves costs and fees that are usually passed on to the end user. There are no free meals and the investment also has associated costs. When you invest in mutual funds, the asset management company (AMC) charges you a fee to manage the funds. This commission, which is a percentage of the invested capital, is called the total expense ratio (TER).
What is the expense ratio?
This is a levy that the fund house charges investors for managing their funds. It includes operating, marketing and administrative expenses as well as fund management fees.
An interesting feature of mutual fund expenses is that they are fully regulated by the Securities Exchange Board of India (SEBI). Thus, no AMC may levy fees that are not within those prescribed by SEBI. This information is posted on the websites of the AMC and the Association of Mutual Funds in India (AMFI) and widely available in the public domain as well. It is calculated on the basis of the fund’s total assets.
Expense Ratio = Total Expenses
Total fund assets under management
For example, if the total expenses of a fund is INR 5 lakh and the assets under management (AUM) of the fund is INR 8 crore, the expense ratio is 0.63%. This means that of the total assets, 0.63% will be charged as plan management fees.
The calculated ratio indicates the unit cost incurred for the management of the funds.
Is the expense ratio the same for all funds?
The fund expense ratio is different for each asset class. Equity plans have higher ratios than debt plans and liquid plans. Also, as the size of the fund increases, the expense ratio percentage continues to decline. The ratios are capped by the limits prescribed by SEBI and as the AUM increases, the percentage decreases.
SEBI has authorized additional limits that may be imposed by fund companies on each class of funds. Thus, the expense ratio falls within a range as shown below in Table 1.
Table 1: By category expense ratio
What impact does this have on an investor’s returns?
The expense ratio indicates how much the CMA charges annually. However, this amount is subtracted from the plan returns before they are distributed. Thus, the net asset value (NAV) of the scheme is adjusted daily for expenses.
Very often, investors compare the performance of unit-linked insurance plans (ULIP) and mutual funds. It is like comparing apples and oranges because in the case of ULIPs the fees are deducted by reducing the number of units held by the investor whereas in the case of mutual funds they are adjusted in value liquidation.
What do higher costs mean?
Generally, the lower the fund’s assets under management, the higher the expense ratio will be. However, relying solely on the expense ratio is like comparing the costs of different cell phone models made by different companies. Ideally, apart from the price, you should compare all other product features and you might find yourself willing to pay a higher price for a higher quality product.
Even within the same category, the expense ratios differ due to the difference in AUMs. For example, the expense ratio of two mid-cap plans is different, as shown below. The Axis midcap plan has a higher AUM and a low ratio and the Quant plan has a low AUM and the expense ratio is high.
Table 2: Higher AUM, lower expense ratio
Similarly, a higher expense ratio does not mean higher returns, as shown in Table 3 below. Of the stock plans featured, the Kotak Bluechip Fund has a higher expense ratio but low returns compared to the Canara Robeco Bluechip Fund.
However, low ratio diets can also have low returns, as shown below. Therefore, checking yields and ratio together to select diets is not a good indicator. The selection of the diet should be done carefully by checking its quantitative parameters.
Table 3: Equity returns after expense ratio deduction
This is just for illustration purposes; if you look at the expense ratio and decide based on that alone, it could result in a different actual return. It is therefore best to avoid deciding where to invest simply based on a comparison of expense ratios.
Are expense ratios relevant to investors?
In the past, investments were made through a distribution channel, so only regular plans were available. Later, SEBI allowed investors to invest directly in funds through AMC. This is when the direct schemes came into existence and slowly a disparity in expense ratios emerged.
As mentioned earlier, expenses are deducted from a plan’s returns. However, if you look closely, deducting a stock plan’s expense ratio from its returns doesn’t make a huge dent.
The difference between direct plans and regular plans can best be understood by drawing an analogy with online purchases versus in-store purchases. For the same product, online prices were found to be much lower than the usual store.
The expense ratio of regular plans is higher than that of direct plans as there is a distributor commission involved in the case of the former. There has been some debate over whether an investor should opt for direct plans or regular plans and the jury has a suspended vote.
There are many fintech portals that now allow you to access mutual funds through direct plans. In fact, as an investor, it is very important to know your preferences and capabilities; if you are financially savvy, you can go ahead with direct plans.
However, if you find that you need advice, do not hesitate to seek the assistance of a financial adviser. An investor comes to stock markets to get higher returns than other asset classes. So if you’re comfortable hiring a financial advisor, at the cost of a 0.5% to 1% lower return per year, you can go ahead with an advisor, if not you can always try the “do it yourself” method.
For borrowing plans, expense ratios are important because returns are limited. If a plan has a higher expense ratio, returns will be lower. For example, consider three corporate bond funds, as shown in Table 4 below. Plan returns are bounded in the range and become lower at higher expense ratios.
Table 4: Debt funds returns after expense ratio deduction
Again, the above is for illustrative purposes only. However, for debt schemes, one should not rely solely on the expense ratio when choosing a scheme. You should check the credit quality portion of the portfolio. Choose a system that has a higher allocation towards AAA and AA rated papers. Any program with a higher allocation to items rated below AA could indicate higher risks.
Therefore, relying on the expense ratio as a metric could be misleading, and more focus should be put on other metrics, especially for equity-focused funds.
There is a lot of noise around the expense ratios charged by mutual funds and an outcry over why one should pay a fee to a distributor. In my opinion, mutual funds have played a very important role in channeling funds from investors to the capital market and investors have been able to build wealth over a long period of time.
By introducing direct plans, SEBI has also ensured that distributors/advisors are vigilant and provide value added services to investors, otherwise there is a plethora of options available to investors. One thing all investors need to be clear about is that there is “no free lunch” and if someone is offering free services there will likely be a catch.
So, while investing in mutual funds, you need to determine what is best for you. Are you comfortable doing it all on your own or do you need guidance in understanding the nuances of investing. If you’re clear on what you’re looking for and decide to go with a distributor, paying a slightly higher expense ratio shouldn’t be a problem when you select a regular plan.
All plans at all AMCs have expense ratios and their impact on the returns you would earn is significant. But this is not the only decisive criterion when selecting a suitable diet. A high spend rate or a low spend rate does not necessarily mean that a program is good. A good fund has a low expense ratio provided it offers good returns.
So, before investing in a fund, make sure you are attentive to the different aspects of the plan, whatever the plan (direct or regular) and choose according to your needs.