Do your mutual funds (MFs) come cheap or are they expensive? We are not talking about the net asset value (NAV) at which you get to buy them. That moves up and down depending on markets. We’re talking about charges that every MF scheme charges you. That’s the question that the capital market regulator, Securities and Exchange Board of India (Sebi) is asking these days. On 23 August, at the annual summit organised by Association of Mutual Funds of India (Amfi), Sebi chairman Ajay Tyagi said that the regulator is examining the expense ratios that MFs get to charge. “The current slab structure and limits were fixed many years ago (in 1996 when Sebi MF guidelines were framed). We are now in 2018 and industry has also grown (₹23 trillion, as per June 2018-end figures); there is merit in re-looking at the expenses," said Tyagi to reporters at the summit’s sidelines. 

There has been a lot of talk lately about expenses that MFs charge. In 2015 and then again in 2017, Morningstar (a global MF research and analytics firm) came out with reports that rated countries on a host of parameters such as disclosures, expenses, transparency and so on. The study rated India as ‘average’ overall, but ‘below average’ on fees and expenses.

Although the Indian MF industry got a top rating on disclosure standards, a large section of distributors weren’t impressed.

The Foundation of Independent Financial Advisors (one of the larger MF distributor associations in India) came out with its own report that contradicted the Morningstar study. Their study said that rather than just looking at a scheme’s expense ratio, we ought to look at the cost of ownership of an MF, which is not just a scheme’s total expense ratio (TER) but also entry loads (stopped in India in 2009), adviser fees, platform charges, taxes on TER, and so on. Both reports have their own methodologies and therefore can't be compared.  

But here’s why expense ratios matter. Assume there are two schemes. Fund A's expense ratio is 2.5% and Fund B charges 2%. Both return 15% compounded annually, before expenses.

After 10 years, 1 lakh invested in Fund A returns 3.24 lakh while Fund B returns 3.39 lakh; 14,725 more. If you stay longer, say, 20 years, Fund B (with lower expenses) yields 97,799 more.

Economies of scale: myth or reality

Sebi rules say that as corpus of funds goes up, the TER should come down. The lower the TER, the higher your returns. But TER includes various charges such as fund manager charges, audit fees, registrar and transfer agent fees, commissions and more. 

Have fund charges really gone down? As per a Mint analysis of 93 equity schemes with a corpus size of at least 1,000 crore, 61 schemes showed a drop in their TER as their corpus went up. The remaining 29 showed a higher TER, despite their sizes going up.

TERs of March 2017 and March 2014 were compared. Schemes like HDFC Equity Fund (largest pure equity fund in our list) reported a TER of 2.22% (March 2017), up from 2.17% (March 2014), despite its corpus going up to 17,949 crore from 11,315 crore.

Other large equity schemes like HDFC Top 100 (₹13,945 crore) and Reliance Multi Cap (₹9,899 crore) have also bucked the trend. But the highest TER in this bucket is 2.97% of Axis Focused 25, followed by 2.83% of Aditya Birla Sun Life Value Fund.

Should expenses come down?

If TER comes down, so will distributor commission, and this has not gone down well with many distributors. “Penetration (of MFs in India) is among the lowest. The expenses that funds charge are also among the lowest in the world," said Dhruv Mehta, an independent MF distributor and chairman, Foundation of Independent Financial Advisors.  

Radhika Gupta, chief executive officer, Edelweiss Asset Management Ltd, said that we cannot compare penetration in India with that of the US, and therefore the charges too.   

In fact, Mehta feels it's time that limits on TER are removed. Competition and market forces would drive down expenses, “like it has happened in the US markets where there are no limits; fund managements costs have come down as size has grown and there has also been a shift from active to passive funds," he said.

Those who say that TERs should come down point to the fact that the current levels and slabs of TER were fixed way back in 1996 when Sebi regulations were formed. “The MF industry has grown to 23 trillion now. The benefits of scale should be passed on to the investors. That said, the fund houses, distributors and investors, everyone should make money. It’s the quantum that needs adjustment," said Suresh Sadagopan, founder, Ladder7 Financial Advisories.

There is merit in saying that as corpus goes up, the TER must come down. Sebi regulations also say so. Then why haven't expenses in many funds reduced despite bigger corpus?  

One reason behind high TERs is the additional 50 basis points (introduced in 2012), for exit load charges and incentive to expand to small towns.

The other reason, experts say, is the fungibility of expenses. Fund management charges used to be limited to 1.25%, but after fungibility was allowed (no internal limits and fund houses can spend as they like within the overall limit), fund management expenses are said to have gone up, and thereby the service tax (earlier) and now the GST (on fund management charges) that is passed on to investors.

“In some large funds, high TERs do not necessarily indicate a high distributor commission. It also indicates that the fund is charging high management fees, which is translating in higher profits," said the head of research at a distribution firm, on condition of anonymity. 

It remains to be seen if Sebi reduces the TER or not. And if it does, would the upper limit of 2.5% come down, or would there be more slabs with further drops in TER as the corpus goes up? Already the 20 basis point exit load charges have come down to 5 basis point and the Beyond 15 (B15) cities charge of 30 basis points has been further tightened to B30. As the SIP inflows appear to have stabilised, perhaps this is a good opportunity for the MF industry to return the benefits of economies of scale to the investor.

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