If you thought that the entry and exit loads that you pay on the purchase or sale of units are the only fees charged by a mutual fund for their market-beating performance, think again. There are other costs associated with your mutual fund investments. The costs charged by a mutual fund to operate and manage the portfolio is captured by a measure called the expense ratio. The net asset value, which determines the value of your holdings, is usually arrived at after adjusting the portfolio return for expenses incurred on marketing, administration and management fees.
Expense ratio
Expense ratio is usually expressed as a percentage of assets managed by a fund. Expense ratios can be found in the half-yearly portfolio statements of funds and represent the amount charged to investors by the asset management company for recurring expenditure. In the Indian context, the expense ratio that can be charged by a fund house is capped by law. According to the Securities and Exchange Board of India (SEBI) rules, the expense ratio is capped at 2.5 per cent for an equity fund and 2.25 per cent for a debt fund. As a fund grows in asset size, the cap on expenses as a percentage of assets declines. This is one of the reasons why you find that funds with a larger asset base such as Franklin India Bluechip, HDFC Equity or Fidelity Equity have lower expense ratios.
Do expenses matter?
After a four-year rally when top-performing equity funds have delivered annualised returns of more than 40 per cent, you may believe that a 2.5 per cent charge on your NAV would have little impact on returns. But the same cannot be said of debt funds, which have struggled to deliver a return of 6-7 per cent.
In a debt fund, a 2.5 per cent expense ratio would shave off 25-30 per cent off your returns! Expenses are, thus, crucial in determining the performance of debt funds and should be a factor to consider when buying a fund. Typically, institutional options within debt funds deliver better returns because of the lower expenses required to services bigger customers.
Though they have not mattered much until now, expenses could assume greater importance for equity funds as well. In the developed markets, equity funds, which find it difficult to outperform the market by more than a per cent or two, are often evaluated on the basis of their expense ratios.
A low expense ratio is also a reason why investors in developed markets are advocated to buy passively managed index funds and exchange traded funds. These funds save on the steep management fee involved in active fund management.
In India, the strong outperformance of active equity funds have more than compensated for the higher expense ratio vis-à-vis index funds. But if the degree of outperformance begins to diminish, passive funds might begin to look more attractive as a low-cost, convenient alternative.
Comparing expenses
While it pays to monitor a fund's expenses, recent performance by equity funds reveal sharply divergent returns. This means that fund manager skills still play a big role in determining equity fund returns in the Indian context. Track record and investment strategy should therefore take precedence over expenses. Investors should check if expenses justify performances.
A fund with a low expense ratio may not necessarily be the best performer and vice-versa. Strangely, index funds too reveal differences in returns not only due to expenses but also because of tracking errors. Hence, focusing on expense ratios as a sole factor in choosing between equity funds is certainly not advisable.
Expense ratios can be useful in choosing between funds of comparable track record, size and investment strategy. The savings in expenses could compound into a sizeable difference in returns over a long holding period of five to ten years.
Choosing debt funds is a more difficult proposition, given the number of options available in the debt space, from deposits to small-savings to funds, and expense ratios may help you narrow down your choices. With heavier competition in this segment, funds do keep a tighter leash on expenses. Among debt funds, passive funds such as fixed maturity plans might be more attractive because of the lower expenses involved.