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.

Selecting the right debt fund

For all their similarities, debt funds are not all alike.  Ideally, to identify the right fund to invest into, one should have a thorough understanding of the risks involved in investing in debt funds and how to assess these risks.  This becomes all the more important because, in my opinion, the potential heartburn from selecting an inappropriate debt fund can be far more than in the case of any other category of funds.  While, over time, I hope to devote posts to talking about these risks and how to assess them, in this post, I’d like to present a straightforward way to understand the types of debt funds and their suitability.

Let me start by suggesting that debt funds can be grouped into three broad categories:

Category A: Closed-end schemes

Category B: Open-end schemes where the fund manager can make significant changes to the average maturity

Category C: Open-end schemes where the fund manager intends to keep the average maturity within a narrow band

This is not a textbook classification but I believe it is the best way to assess the suitability of a fund. To facilitate understanding as to which funds fit in what category, I will be linking these with the categories put forth by Value Research.  You may notice a certain ambiguity to the definitions (what, for instance would ‘significant’ or ‘narrow’ mean?)- but interpreting these will be less relevant once I link these to the categories of Value Research.

Let me now elaborate on these categories.

Category A : This is really the same as Value Research’s category: Fixed Maturity Plans.  Like deposits, these funds have a fixed tenure. Amongst all categories, these carry the highest level of predictability as to the returns one can expect. The returns on such funds virtually mirror the returns of the underlying debt instruments. This is a key reason why a number of advisors strongly encourage their clients to invest in these funds.

On the flip side, these funds typically carry severe restrictions in case we need to withdraw before the term of the fund. It is possible we may not even be able to do so.  For this reason, these are best suited for investors with crystal clarity about the time they would like to stay invested.  The right fund is one whose tenure matches one’s own investment time horizon.

Do bear in mind that at the time of investing, we do not know the exact composition of the portfolio of the fund. Once the portfolio is disclosed, if we don’t like what we see, it may not be easy to walk out. It, therefore, becomes important to get as much clarity as we can, about what the portfolio will look like, before we invest our money. Additionally, at the end of their tenure, these are compulsorily redeemed- we cannot defer exiting the fund beyond that time.  This is important because taxes, if any, become due the moment we redeem an investment.

Category B: This would include funds in the following categories of Value Research: Income, Gilt-Medium and Long Term, and Gilt-Short Term. 

These funds are best suited for investors who are looking for the highest returns (among debt funds) and are willing to take higher risk, and to time their entry into, and exit from these funds.  To put it differently, these funds are an acquired taste- these are not for everyone. These carry the highest level of unpredictability as to the returns one can expect.  Historical 1 year returns show that it is not uncommon to see a double-digit difference between the returns of the best performing and the worst performing funds, particularly in the Income and Gilt-Medium and Long Term categories.  In the turbulence of mid-July to mid-August, 2013, the worst performing funds in each of these three categories had lost between 5% and 12%. 

Category C: This would include funds in the following categories of Value Research: Liquid, Ultra Short Term, and Short Term.  Like the funds in Category B, being open-end schemes, these allow one to defer one’s exit (and taxes) for as long as one wants to.  But because of their targeted maturity being more narrowly defined than those in Category B, there is a higher level of predictability to their returns.

Here is how I look at their suitability, relative to comparable bank deposits:

• For someone with an investment horizon of up to 3 months, funds in the Liquid category can be a good choice and, in my opinion, can be expected to give better returns than a bank deposit. 
• For someone with a investment horizon of over 3 months and less than a year, funds in the  Ultra Short Term category can be a good choice and in my opinion, can be expected to give better returns than a bank deposit. 
• For someone with a time horizon of over a year but less than 3 years, I would recommend going for a bank deposit rather than a debt fund. 
• For someone with a time horizon of over 3 years, and with no taxable income or who is in the lowest tax bracket, I would again recommend a bank deposit over a debt fund. 
• For someone with a time horizon of over 3 years, and in the higher tax brackets, funds in the Ultra Short Term and Short Term categories can be a good choice and can be expected to give better returns than a bank deposit, after adjusting for taxes.

To take all of this further towards deciding which specific fund to select, as I mentioned at the start, it would help to understand the risks involved in investing in debt funds and how to assess these risks.  I hope to dwell on these in detail in future posts.  For now, I would like to close with a mention of one important indicator to consider while selecting a fund: the expense ratio. 

The expense ratio tells us how much is deducted as expenses by the fund house from whatever they have earned from their investments.  While this is an important indicator across all kinds of funds, it is particularly crucial in the context of debt funds.  Here’s one way to look at this: if two funds follow identical strategies and take identical risks, the fund with the lesser expense ratio will give better returns.  A note of caution: As important as this is, in my opinion, there is generally a lack of transparency regarding this indicator across the mutual fund industry.  Though, in all fairness, Value Research and Morningstar provide this indicator for most funds, most fund houses don’t disclose this in their monthly fact sheets.

For that reason, personally, I focus only on funds where the expense ratio is disclosed transparently, month after month, in their fact sheets.