August 17, 2014

Could your mutual fund be fleecing you?

All investors in mutual fund schemes pay a charge on their investments.  Not all are aware, though, of the nature of this charge, the amount of this charge, or the fairness of this charge.  Yes, there are legal limits defined as to what a fund house may charge an investor, and I am not aware of any fund house violating these.  However, if we don’t know how much we are being charged or do not have a sense as to the fairness of this charge, it throws up the possibility of us being overcharged, in a manner of speaking.  There is also the possibility that we may be missing out on better, less-expensive opportunities, so to say.  In this post, I propose to offer some thoughts on how you could ascertain as to how much is a fund charging you and the fairness of that charge.

There are two parts to the charge that investors in any mutual fund scheme pay: the costs incurred by the fund house, and the fees that are charged by the fund house.  These expenses are charged on a daily basis, and are factored into the calculation of the daily NAV.   Since the NAV already includes these, the exact charge may not be clearly visible.  You need to know what to look for, and where to look for it.

Introducing the expense ratio

In my previous post, I briefly alluded to the expense ratio and its importance. Let me get into a bit more detail.

The expense ratio of a scheme is a simplified representation of the annual expenses charged to a scheme, expressed as a percent of the average amount of money managed under the scheme.  Fund houses disclose this in their financial statements at the end of each year.  However, since expenses are charged daily, and not at the end of the year, fund houses also disclose, throughout the year, what is sometimes referred to as the current expense ratio (i.e. the ratio they propose to maintain for now, until further notice).

The current legal limits on the expense ratio cap this at around 3.00% or so (there is a somewhat complex formula).  Crudely put, and at the risk of oversimplification, if the fund manager of a scheme expects to generate a return of, say, 12.50% p.a. (before accounting for expenses) and the current expense ratio of the fund is, say, 2.50%, then the return to an investor in that scheme can be expected to be 10.00% p.a. (i.e. 12.50% – 2.50%).  Thus, if two funds have identical return potential (before adjustment of expenses), then the fund with the lower expense ratio can be expected to give a better return to the investor.

(Note: the term, ‘current expense ratio,’ is not widely used but any reference to the expense ratio outside of a financial statement can be reasonably assumed to be a reference to the current expense ratio, unless otherwise mentioned.)

How much is too much?

Generally speaking, most experts agree that debt funds should have lesser expense ratios than equity funds (given their relative return potential), and that larger funds should have lesser expense ratios as compared to smaller funds (given their economies of scale).  Funds requiring a minimum involvement of the fund manager (e.g. index funds) are generally expected to have lower expense ratios than those that are actively managed.  Funds that are designed to incentivize financial advisors are generally expected to have higher expense ratios than comparable funds that are not. 

Current data on the Value Research website shows that most equity funds have an expense ratio in excess of 2.00%, with the highest being in excess of 3.00%, and the lowest being less than 0.50%.  Amongst debt funds, those in Value Research categories of FMPs and Liquid appear to have the lowest expenses (most below 0.50%).  In the other categories of debt funds, the expense ratios appear to be much more scattered- some in excess of 2.00%, quite a few below  0.50%, and most in-between. 

So, what should we make of this?

If a fund that we have invested into (or propose to do so) has a significantly higher or lower expense ratio than its peers, or it breaches the above generalizations, it would be useful to understand the reasons for that.  Let me illustrate how I might do this, with a few observations from the Value Research data.  A quick caveat: these illustrations are based on the data on the Value Research website on 15 August, 2014.  Expense ratios can change over time and this should be factored into any assessment that one makes.  I will touch upon dealing with this, ahead in the post.

  • Amongst the domestic, diversified equity funds, there are 5 funds that currently have expense ratios in excess of 3.00%.  As far as I can make out, two of these funds have a very questionable historical performance, and I cannot see any compensating factor for me to consider investing in these.  Then, there are two other funds whose performance is in line with the average equity fund’s performance but, again, there is no compelling, compensating factor to consider investing in these over most of the other equity funds.  There is, however, one fund, which appears to justify the high expense ratio on multiple parameters, including its performance, and I would be open to considering investing in this fund.
  • There are a handful of index funds with expense ratios of less than 1.00%.  These don’t breach the earlier mentioned generalization, but are worth looking into because of the significant difference in their expense ratios, relative to most other equity funds.  Again, the historical performance can provide clues.  In my assessment, the performance of these funds was good enough to throw a question mark over about half the actively managed funds which had far higher expense ratios and comparable, or less-than-comparable performance.  However, their performance was far below the performance of the funds which I, personally, qualitatively consider as worthy of investment and hence I would see no reason to invest into these index funds.
  • There are 13 debt funds which currently have expense ratios of 2.00% or more.  In my assessment, only 2 of these justify their high expense ratio in terms of their historical performance.  Even so, in my understanding of debt markets, I would say that the odds of delivering above-average performance with such a high expense ratio are extremely low.  Hence, notwithstanding their performance, I would not consider  investing in these funds.

Where are the current expense ratios disclosed?

There is little uniformity in the way fund houses disclose the current expense ratios of their schemes.  As far as I can make out, all mutual funds disclose the current expense ratio of each scheme somewhere on their respective websites. Whenever there is a change, the only legal obligation of a fund house towards its current and prospective investors is to disclose the new expense ratio on its website within two working days of that change.  Some fund houses go beyond this obligation and periodically disclose the month-end expense ratios in their monthly fund fact sheets.  Unfortunately, most funds do not.  What that means is that unless you regularly visit such a fund house’s website, you could well miss out on a change in the expense ratio.  What compounds the issue is that it is not uncommon to see expense ratios change frequently and/or significantly.  In addition, most fund houses do not keep records of historical changes to their expense ratios on their websites (at least, in a manner that can be easily accessed).

To illustrate this point, I would like to share something that was recently brought to my attention.  An investor showed me documents that he had obtained, pertaining to expense ratio disclosures of one of the biggest debt funds in the country.  According to these documents, the expense ratio of the direct plan of that fund was fixed at 0.49% w.e.f. 6 March, 2013 (the earlier expense ratio could not be ascertained).  It was then changed to 0.60% w.e.f. 2 April, 2013.  It was again changed to 0.80% w.e.f. 10 June, 2013.  This fund house does not mention the expense ratios in its monthly fact sheets and as far as I could make out, it does not keep a record of historical changes to its expense ratios on its website.

So, what is one to do?

The issue of lack of transparency can be overcome through a frequent, periodic check on fund house websites to see if there is a change in the expense ratio.  For a more permanent solution, one could also try and apply pressure on errant fund houses through direct engagement or through the industry body (AMFI), or through the regulator (SEBI).  However, in my understanding, there is no way out of the issue of inconsistency in expense ratios (i.e. tinkering these frequently or setting these arbitrarily) other than for a fund house to demonstrate its good intentions on its own. 

Personally, I regard transparency and consistency of good business practices as fair expectations from any fund house.  To me, these are as important (if not more) as the fund performance.  For that reason, I avoid investing with fund houses that compromise on these issues, no matter how good their fund performance may be.

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