When it comes to investing, one of the first things we do is to see where we can cut costs and maximize returns. Take the case of debt funds. A cursory glance at medium- and long-term bond funds tells us that 15 of the total of 53 funds in this category charge more than 2% fees annually, according to mutual fund tracker Value Research Ltd.
A 2% fee, or expense ratio, built in an equity fund doesn’t pinch you hard because you’re used to earning way above 20% returns from the equity markets if you are patient and stay invested for a long time. But look at this cost in the light of 7.64% average returns that you made in your bond in the past three years and you will understand what we’re saying (see graph B).
Also See Costly Factor (Graphic)
What is expense ratio?
Every time you put money in your mutual fund, it incurs a cost to manage it. As asset management companies are full-time professionals, whose main job is to manage other people’s money, they have a right to charge you a fee. It’s their bread and butter. They also pay to agents and distributors for procuring investors and brokers for carrying out transactions in the debt market. They also bear other administration charges throughout the year.
Just like any other mutual fund scheme, your debt fund deducts all these charges and pays you the rest. As per rules prescribed by the capital market regulator, the Securities and Exchange Board of India (Sebi), your debt fund can charge a maximum of 2.25% for assets up to Rs100 crore. For the next Rs300 crore, it charges 2%; for the Rs300 crore after that 1.75% and 1.50% for all assets above Rs700 crore.
Equity funds can charge 25 percentage points higher in all the above tiers than debt funds. As equity funds are more volatile than debt funds and, therefore, require extra effort to be managed and also sold, they are allowed to charge marginally more than what debt funds can charge.
Also See Lower Expense Ratio, Higher Returns (Graphic)
Your fund’s corpus size is the biggest reason behind its charges. Size brings economies of scale. Here’s how. A mutual fund scheme incurs fixed and variable costs. Say, there are two funds, scheme ‘A’ with assets of Rs1,000 crore and scheme ‘B’ with assets of Rs100 crore. Assuming both these funds have the same cost structure, the cost of the Rs1,000 crore fund gets shared by a large number of investors, as a result of which its cost per unit comes down.
Typically, your fund’s cost comes down as it grows in size. The average corpus size for the top 20 funds that have the highest expense ratio is Rs105 crore, and Rs933 crore for the bottom 20 funds with the least expense ratio.
Can they exceed the formula?
No, they can’t. Sebi doesn’t mandate how much funds can charge. It merely draws an outside boundary that they cannot cross. Within this, debt funds are free to fix their costs depending on several factors.
Yield movements: Fund officials claim that the kind of expenses they charge to their fund can move up or down depending on how the yields in the bond markets move. “If the yields on bonds, in which we have invested, fall, the bond prices rise and so do our net asset values. In this case, since returns rise, that gives us the extra margin to marginally increase the expenses, we can charge to the scheme,” says a marketing official of a public sector fund house who did not want to be named.
This is also the time when agents push debt funds to investors. Fund managers claim that few bond funds marginally increased their expense ratio between August 2008 and January 2009 when the benchmark 10-year government security yield fell from 9.47% in July 2008 to 5.24% on January 2009. Bond funds returned around 30-40% in this period on account of falling yields and rising bond prices.
Agent commissions: Typically, debt funds don’t pay agents an upfront commission (at the time of investment). Instead, they pay trail commission to agents for as long as the investors stay with the fund. Fortis Investment Management (India) Pvt. Ltd’s fund manager (fixed income) Alok Singh tells us that fund houses regularly get updates from distributors on what other fund houses are paying as commissions. “The price we pay to agents is quite flexible. This is also the reason why many debt funds charge lower expense ratios than the maximum limit,” says Singh.
What should you do?
The lower the expense ratio of your debt fund, the better it is for you. However, don’t look at expense ratio alone. Look at a combination of a few things.
“Look at performance, apart from expense ratio. Watch out if a high expense impacts your debt fund’s performance and then take a call,” says Lakshmi Iyer, head (fixed income and products), Kotak Mahindra Asset Management Co. Ltd.
The safest way to pick any debt fund is to look at a combination of large size and good performance. Typically, as the size goes up, costs automatically come down.