Be watchful of expense ratio you pay if your fund manager can't outperform

A recent Morningstar report had some good and some bad news on expense ratios in the Indian mutual fund industry. The good news is that India’s grade on fee and expenses has improved from ‘below average’ in 2017 to ‘average’ in the latest report.

This happened due to the regulator introducing new expense ratio slabs in September 2018. The bad news is that with an asset-weighted median expense ratio of 1.93 per cent, equity funds in India are the fourth-most expensive. Clearly, investors need to be watchful of the expense ratio they pay to fund houses.  

This has become all the more important in light of the fact that active funds are finding it hard to beat their benchmarks, especially in categories like large-caps. Over the past five years, only 13 out of the 29, or 44.8 per cent large-cap (regular), funds have managed to generate higher returns than the Nifty total return index.

“Funds with excessively high expense ratios have absolutely no chance of outperforming their benchmarks,” says Avinash Luthria, a Securities and Exchange Board of India-registered investment adviser and founder, Fiduciaries. Hence, he suggests using expense ratio as an elimination criterion while selecting funds.

Investors can go with direct funds (instead of regular ones) to avoid paying high expense ratios. “How important the expense ratio is to returns becomes clear from the outperformance generated by direct funds over regular ones,” says Kunal Bajaj, head of wealth management, MobiKwik.

To cite an example, the best-performing large-cap fund in the direct category over the past five years — Axis Bluechip — gave a compound annual growth rate of 13.30 per cent. Its regular counterpart was able to generate 11.93 per cent, or 137 basis points (bps) less.

One positive feature of the Indian market is that retail and institutional investors have access to the same funds. The latter watch expense ratios very closely. “In categories where institutional investors invest, like Nifty50 exchange traded fund (ETF), liquid funds, etc investors can take the advantage of the low fee, which fund houses offer primarily to attract big institutional money,” says Luthria.

In a scenario of shrinking alpha, financial planners have begun to suggest that investors start making allocation to low-cost passive funds. They advise making a start with 50 per cent allocation to passive funds within the large-cap category. Thirteen ETFs benchmarked to the Nifty50 are available with expense ratios of 10 bps or less.

“However, go with low-cost ETFs that have garnered considerable assets under management. Many fund houses offering very low-cost ETFs now are subsidising them. They may be forced to hike their expense ratios in future if their fund size does not grow,” says Bajaj. Besides expense ratio, look for funds with low tracking error and higher trading volume (in the case of ETFs).

One alternative that has emerged in recent years is smart-beta funds. “When you move to a passive fund, you sacrifice the possibility of enjoying alpha altogether. Smart-beta funds have the capability to generate alpha and their expense ratios are also in the intermediate range,” says Kalpen Parekh, president, DSP Investment Managers.

Be wary of investing in sector funds. Besides carrying high concentration risk which makes them very volatile, they also have high expense ratios. The expense ratio range for sector funds (regular) is 2.13-2.74 per cent, with the average being 2.48 per cent. Also, avoid fund houses that hike the expense ratio overnight, confident in the knowledge that most investors will not notice. If this happens in a fund you hold, re-evaluate whether you should continue with it.  

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