Mutual Funds in India have grown by leaps and bounds over the past few years. Investors have enjoyed good returns in what is one of the longer bull runs in the market since the 2008 crash. Most Mutual Fund houses have made record profits and the big ones have grown bigger. Some have even gone IPO, and listed in the bourses, making the fund managers and employees very rich in the process.
But what about the investor? Is s/he getting a good bargain as the fund houses and distributors make merry? How do they actually make money? We understand more in this post.
An Expense ratio is the charge that a mutual fund collects from its investors. This is how they recover their costs and make profits. The expense ratio reflects in the daily NAV calculated and published by the fund house.
They vary by fund category with equity funds being more expensive than liquid funds. Any fund that requires more ‘expertise’ and ‘marketing’ will usually have a higher expense ration. Thankfully, in the interest of the investors, SEBI (the market regulator) has capped limits on them.
There is now a lot of discussion on how the expense ratio limits were set by SEBI when the industry was nascent and have become ‘archaic’ leading to the Mutual Funds making a lot of money, perhaps at the ‘expense’ of the investor. Now with the industry touching 25 lakh crores, these need to be revised.
An Expense ratio is very important for an investor because it affects the net returns. While they may appear small, over time say 20 years, they can run into lakhs of rupees.
How? Let’s take an example. A 2.5% expense ratio over 20 years means that your initial investment of 10,000 earning 15% returns p.a. before expenses becomes Rs. 98 639 vs. Rs. 1,63,655. That’s a whopping one-third of the corpus.
Hence it makes sense to choose fund classes and funds that are lower in expense ratio, and meeting the investment objectives of the investor. Direct plan mutual funds usually have no distributor commission paid and hence have a lower expense ratio by up to 1.5% or 150 basis points. Over the long term this could mean up to 40% more in the final corpus.
The Total Expense Ratio or (TER) at a fund level, covers most of the Fund House’s costs. These are all recovered from the investor. The following ‘items’ are part of the expense ratio:
There are two more ‘interesting items’ here:
Let us take an example to illustrate the calculation of expense ratio of a mutual fund scheme.
|Year||Beginning Balance||Returns||Expenses||Ending Balance|
While expense ratio is an important factor, it is not the only factor.
The risk-return equation matters across fund categories. For example, Liquid funds have lower expense ratio but also give lower returns whereas equity funds have higher expense ratio but in the long term give much higher returns. Here since most good funds give returns in a similar range, the expense ratio doe smatter.
Within a fund category, this matters too. For funds that offer higher returns, such as equity funds, this factor becomes more important. One must look at consistency of returns and fund pedigree, process maturity. If these are superior and the fund does much better than benchmark consistently, then it makes sense to give greater allowance for a higher expense ratio. The net returns from the better fund may be much higher even with say a 50 basis point or 0.5% extra expense ratio.
However if a fund consistently shows a high expense ratio, and yet the returns are not great, ie consistently below the benchmark, then one should exit out of the fund.
This is because a consistent gap, say 50 basis point difference in the expense ratio of two identical mutual fund schemes in same category can impact the growth of your investments.
Let us dwell on the distributor commission a bit here. Typically, a direct plan has an expense ratio of around 1%, while regular plans cost 2.5% per year. The difference is about 1.5%. This may appear a small difference, but could decide whether you holiday in New Delhi or New York or retire at 45 or 65. Over time, the difference in the expense ratio would add up significantly, thanks to the power of compounding. For example, a SIP of just Rs. 5,000 a month in a direct plan, over 25 years, would yield an additional Rs. 28 lakh over a regular plan.
Therefore, over the long term, regular plans eat into 40% of your wealth. The simple decision to ‘let the agent fill the form’ could end up costing you big over time!
No, the commissions are earned, not just the day you make your investment but for as long as your money is in the scheme. Shocked? This is known as trail commission.
Agents keep earning commission at varying rates for as long as you’re invested in a scheme. So if you have a SIP going for the past 10 years, you’ve been paying your agent for each day of the past 10 years. Even if you haven’t met or spoken to the agent, he/she is still receiving payment. This is how may agents, despite doing largely clerical work, seem to have it made!
It is said that trail commission is like pension for the distributor. The question, is if you are also getting a pension income.
Though mutual fund expense ratios have somewhat come down since 2012, they need to come down faster as the industry has grown FOUR times since 2012. And globally they are among the highest!
Since 2012, the regulator SEBI in order to drive MF expansion, made some changes in the expense ratio norms. These can be summarised as below.
The GST is charged only on the fund management charge and not on the other line items. This favours the AMC selectively.
This means the fund house can increase fund management charge (the core expense) and make a fatter profit by becoming more efficient in other matters or paying distributors lesser. They would got for the max TER allowed in a view to make a larger profit
It allowed an additional charge of 20 basis points (of AUM) in lieu of an exit load; but the compensation was 5x to 7x what they actually incurred. Though this has come down to 5 bps it is still a drag.
SEBI allowed expenses of 30 basis points for business growth beyond the top 30 cities. This means investors are paying for the AMC’s growth!
All of this means that an equity mutual fund can now charge a maximum of 3.3 percent compared to 2.5 percent earlier. In the bargain the investor has suffered. In many countries, the fund management costs are about 50 bps to 75 bps where as in India they are twice. The above points illustrate that there has been scope for enough padding.
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