Expense Ratio & MF Returns

In the final week of June, several asset management companies (AMCs) listed on the stock market experienced a significant surge in their share prices, with gains exceeding 10 per cent. This sudden increase can be attributed, in part, to the decision made by the Securities and Exchange Board of India (SEBI), the capital market regulator, to defer the rationalisation of the total expense ratio (TER) for mutual fund (MF) schemes. The TER represents the expenses that AMCs can charge their investors and serves as a crucial source of revenue for these companies. Initially, it was anticipated that SEBI would revise the TER, thereby impacting the financials of AMCs. However, SEBI Chairperson Madhabi Puri Buch said that the regulator will soon release a second consultation paper on TER. 

She hinted that the new proposals would be less stringent than the earlier ones, and that the mutual fund industry would be happy with them. SEBI is considering a number of factors in its review of TER, including the need to protect investors, the cost of managing mutual funds, and the competitive landscape. She said that the regulator is committed to finding a balance that will benefit all stakeholders. Despite the seemingly low value of the expense ratio, its significance lies in the substantial impact it can have on the returns generated by MF investors. In the following paragraphs, we will delve into the concept of TER and explore its implications for investors in mutual funds.

What is TER?
TER is a measure of the overall costs or expenses associated with running a mutual fund or investment scheme. It encompasses various expenses incurred in managing the fund, including management fees, which tend to be the largest component of the TER. These fees cover expenses such as fund managers’ salaries and research fees. Other costs include brokerages and taxes related to the fund’s securities transactions, fees paid to trustees, registrars, transfer agents, custodians and personnel of the trustee and asset management company, as well as legal and accountancy fees, sales and marketing expenses, among others. The TER is typically expressed as an annualised percentage of the fund’s assets. 

Since the assets of open-ended funds fluctuate on a daily basis, the proportionate TER is factored into the scheme’s net asset value (NAV) when it is published each business day. Over time, the TER should either stabilise or decrease as the fund grows larger. In India, the expense ratio is fungible, meaning there is no specific limit on individual types of expenses as long as the total expense ratio remains within the prescribed limit. The regulatory limits for TER that can be incurred or charged by a mutual fund AMC (asset management company) are specified under Regulation 52 of SEBI Mutual Fund Regulations. Effective from April 1, 2020, the TER limits have been revised according to the prescribed regulations.

Why TER Matters
Sometimes, seemingly insignificant factors can have a significant impact on your investments. This holds particularly true for TER, which may appear negligible in the short term but can heavily affect your portfolio returns over the long term. To illustrate this, let’s consider a scenario where you invest Rs 1 lakh in a mutual fund scheme with an average return of 15 per cent. In one case, the scheme has an expense ratio of 0.25 per cent, while in the other case it has an expense ratio of 2.5 per cent. After 10 years, the corpus in the scheme with a 0.25 per cent expense ratio would be around Rs 395,000. However, with a 2.5 per cent expense ratio, the corpus would only be around Rs 325,000. The difference of Rs 70,000 (almost 18 per cent) between the two schemes accounts for a staggering 70 per cent of your initial investment.

Even with a five-year investment horizon, the difference in returns is still around 10 per cent. Hence, it is crucial not to overlook the expense ratio when making investment decisions, as a higher expense ratio can significantly impact your investment performance. Let’s consider the following scenario. There are over 713 equity funds (direct category), including ETFs and index funds with an average expense ratio of 0.7 per cent. This means that approximately Rs 14,500 crore is being spent on managing funds worth around Rs 22.04 lakh crore. If we exclude index funds and ETFs, there are around 470 funds with an average expense ratio of 0.92 per cent, resulting in a total expense of around Rs 14,000 crore. 

Index funds and ETFs have a lower average expense ratio of 0.26 per cent. One might argue that funds with higher expense ratios could generate higher returns to compensate for the expenses. To test this, we conducted a regression analysis between the one-year returns provided by funds and their expense ratios. Surprisingly, we found no significant impact of the expense ratio on returns. There was hardly any relation between the expense ratio and one-year returns. Even when testing the significance of the regression between the expense ratio and returns at different time intervals with a 95 per cent confidence level, we found it to be insignificant.

Therefore, the expense ratio does not determine either the long-term or short-term returns of a fund. Furthermore, in tough years when equity funds have yielded negative returns on average, the expense ratio further reduces the returns. Hence, it is advisable to invest in funds with lower expense ratios, while considering other factors such as risk. Although a high expense and turnover ratio can weaken a mutual fund’s performance, it should not be the sole criterion for excluding a fund. What matters is the fund’s return after expenses, which is calculated from NAVs. A fund that can outperform its peers on a risk-to-return basis, taking expenses into account, is a clear winner and worth considering. However, if the expenses significantly exceed the category average, caution should be exercised before committing funds.