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What is Expense Ratio?
'Expense ratio' is nothing but the recurring cost per unit- incurred to operate a scheme - and is charged to its assets. Such expense ratio is calculated periodically but is charged daily on the NAV. This annual recurring expenses is disclosed every March and September and is expressed as a percentage of the fund's average weekly net assets.
It, therefore appears, that is no free lunch here. Mutual funds deduct their expenses from investors invested funds. It may be taken as a service fee charged by mutual funds for taking care of investors investments.
The return investors receive from their mutual funds investments is net of expenses incurred by them while managing the funds. These expenses include fund management fee, agent commissions, registrar fees, and selling and promoting expenses. Now you know that MFs incur expenses while managing your funds, the next question in your mind could be how much.
How 'Expense Ratio' impact investor's return
Another way of looking at 'expense ratio' is that it is the amount investors pay a fund annually to manage their funds. We may take an example to elucidate this point further. Let us say, an investor has invested INR 1,00,000 in a mutual fund, whose expense ratio is 2 per cent. The investor would be paying INR 2, 000 annually to the mutual fund to manage his/her funds. In case the investment is a diversified equity funds where the average returns for the last year has been around 22 per cent per annum, the investor's return would be actually 20 per cent. And, in case the invested was in a debt fund, where the average return has been around 9 per cent, the actual return will be 7 per cent. NAVs of a fund are declared net of the expenses of the mutual fund.
Let us take an example to see the impact of different expense ratios on an investment of INR 1,00,000 with average return of 12 per cent per annum with varying expense ratios.
A higher expense ratio will mean lower return for the investor and vice versa.
SEBI regulations on expense ratios
Different MFs have different expense ratios, and to regulate this SEBI has put a cap that a fund can charge, which are:
The Securities and Exchange Board of India (SEBI) had further allowed mutual funds to increase the expense ratio by 0.20 percentage point for all investors and another 0.30 percentage point for investments coming from "B-15" towns - towns that are below the top 15 in the country in terms of MF assets.
SEBI also provided a recent option for investors to buy funds directly from MFs (not through the distributor). If bought directly, the NAV, called the direct plan NAV, will not bear the fee paid to distributor. That means the direct plan NAV will be higher than the regular NAV to that extent.
Expense ratios across asset classes
From the discussions above we may come to a conclusion that all mutual funds products do not have similar expense ratios, e.g, equity funds normally have higher expenses ratios (they also have the potential to give the highest returns) where liquid funds and index funds have lower expense ratios and expense ratios for debt funds come in between.
The following table will give a better idea of the expense ratios of various kinds of mutual fund products. You will notice from this table that there is a significant difference in expenses charged for actively and passively managed equity funds - how this is leveraged by advisors is discussed later in this article. You will also observe that expense ratios in the debt segment are much lower than the SEBI prescribed caps - which indicates a principle of "what the market can bear". Expenses charged are largely influenced by return expectations from each asset class.
Advent of direct plan: new dimension on expense ratios
From January 1, 2013, all mutual funds were asked to offer a new Direct Plan with their schemes so that investors who did not want to avail the services of a distributor, could go directly to the fund house and buy the same funds at a lower expense ratio, as the fund houses would pass on the savings in distribution costs to these direct investors. Expense ratios and the gap between direct plan NAVs and regular plan NAVs have since then become a key focus area for distributors. There is now a greater need for distributors to be able to demonstrate their value add for their clients to continue utilising their services versus going direct.
Advisor vs distributor: expense ratios play a key role here
SEBI's recent Investment Advisor regulations have indirectly sharpened the focus on expense ratios. According to these new regulations, intermediaries will have to choose between being a distributor (who receives commission from AMCs) or an advisor (who receives fees from investors, but no commissions from AMCs). If an advisor were to offer regular plans (with regular expense ratios) and then seek a fee from his clients, that would amount to a double intermediation cost for such investors. Advisors would naturally therefore seek to offer direct plans as lower cost alternatives and charge a fee separately for their advice.
Another dimension that comes out of the separation of advice from distribution is that one should expect over time the advisory fraternity to demand more variants of low cost products - such as exchange traded funds and a variety of sectoral index trackers. You have seen in the tables above, the sharp differentials between actively and passively managed equity funds. Advisors who believe their value add comes from asset allocation as well as sectoral allocations within equity, may want to offer very low cost index trackers to their clients, generate alpha with their calls, and then charge a fee for their advice. Expense ratios become a key focus area here, as advisors will be keen to strip off all other costs that their clients would have otherwise incurred.
Whichever way you look at it - distribution or advisory - expense ratios have now become a much more relevant factor to consider, than they were a few years ago.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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