Fee does not matter in actively managed equity funds

The Securities and Exchange Board of India (Sebi) has been pushing reforms to lower mutual fund charges. Recently, it lowered the additional expense they can charge in place of exit loads from 20 basis points (bps) to 5 bps, a 15 bps reduction. It had earlier mandated that any exit load charged should be deposited back in the scheme, and instead fund houses could charge extra 20 bps, but this provision was misused by fund houses. Sebi has also reduced the number of cities where mutual fund houses can pay higher distribution fees to agents, which effectively makes it difficult for fund houses to charge additional expenses to fund.

For investors, every cost-saving does mean higher returns. But with a cap on the maximum fees that a fund house can charge, should investors worry about expenses? The answer depends on the fund category. It matters very little in actively-managed funds. But in index funds and debt schemes, it can make a difference. “When we are ranking actively-managed equity funds, the expense ratio matters little as most better-rated funds have expenses within a close range,” says Kaustubh Belapurkar, director, fund research, Morningstar Investment Adviser India.

Suresh Sadagopan, Founder of Ladder7 Financial Advisories, echoes similar views. “The actively-managed equity funds that we recommend to clients are those that have outperformed their benchmarks. In their case, the expense ratio is justified,” says Sadagopan. Cost-conscious investors have another option — direct plans of the same schemes. Take Axis Bluechip Fund (erstwhile Axis Equity), the best-performing large-cap fund, as an example. The direct plan has an expense ratio of 0.99 per cent and the fund’s one-year return is 21.33 per cent. Its regular plan charges an expense ratio of 2.1 per cent and has a one-year return of 19.57 per cent. The average difference in expense ratio between a regular and direct plan is a good 63-116 basis points for different categories. But to go direct, you need to do your research and select the right scheme.

Industry sources say that Sebi drastically cut the additional expense ratio because it found that some fund houses were overcharging investors using this avenue. This fee is supposed to be charged instead of the exit load (which fund houses were asked to deposit in the scheme), but fund houses charged a full 20 basis points even in schemes where the exit load was lower. In some cases, this fee was charged even in funds that didn’t have an exit load. If you have Rs 1 million invested in a fund and the fund house charged 20 basis points extra expense, over 10 years an investor would lose Rs20,181.

Higher expense ratios affect index funds as well as debt schemes. Index funds track an index and the lower the fees, the better it is. It’s the cost that should be the sole deciding factor in an index fund. If you look at index funds that track the BSE Sensex, their expense ratios are between 0.05 per cent and 0.5 per cent. A difference of 45 basis points can make a considerable difference to your returns over the long term.

In the case of debt funds, where returns are typically in single digits, a higher expense ratio can make a huge difference. “Just as in equity funds investors should look at risk-adjusted returns, in debt funds they should look at cost-adjusted returns,” says Vidya Bala, head of mutual fund research, FundsIndia. She points out in categories such as liquid, short-term and ultra-short-term, funds don’t need to take any risk for short-term paper that are held until maturity. Investors should, therefore, pay heed to expense ratios in such funds. If you look at liquid funds, the expense ratios for regular funds can vary from 0.10 per cent to 1.06 per cent. Funds with higher returns have an expense ratio of maximum 30 basis points.

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