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Business News/ Money / Calculators/  How important are expense ratios to debt funds?

How important are expense ratios to debt funds?

Your mutual fund charges a fee to manage your money. So, how important is this fee while choosing a fund?


Time and again, we’ve told you that expense ratios are one of the key ingredients for a debt fund. All things being equal, a higher expense ratio nibbles away at your mutual fund scheme’s returns, especially the debt funds, since here the returns are typically subdued. But are things really equal? Do expense ratios really matter? And should you invest in a debt fund, just because of low expense ratio?

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Broadly—and very broadly speaking—low expense ratios typically result in higher fund returns, especially in debt funds. All equity funds are allowed to charge a maximum of 2.5% total expense ratio (TER) and all debt funds a TER of 2.25%. Over and above this, the capital market regulator, Securities and Exchange Board of India (Sebi) allows all funds to charge 30 basis points more as an incentive to penetrate in smaller towns and an additional 20 basis points as exit load charges.

To keep things simple here, we took only ultra short-term bond funds (53 schemes, as per Value Research) and short-term bond fund (43) categories. We left out liquid funds because there is very little retail money there. And we left out long-term bond funds because given that their ideal minimum investment tenure is 3 years, one or two good calls taken by the fund managers can negate the impact of high expense ratios in the long run. It’s only in the ultra short-term and short-term bond fund categories that the expense ratios can make a difference.

In fact, in the short-term bond fund categories, there are outperformers and underperformers across various types of expense ratio brackets. In other words, schemes with high expense ratios have done well and badly as well as those with low expense ratios. This begs the question: how important are expense ratios?

In earlier times, almost all debt funds used to be plain-vanilla. But over the years, as interest rates started to fall and funds started to earn extra returns by identifying well-managed companies with weaker credit ratings, many debt funds started to blend in a credit strategy. Those that yield extra returns get more legroom to charge some more, as part of the overall TER.

“But we need to keep in mind the sensitivity of expenses to a fund’s overall returns," says Lakshmi Iyer, chief investment officer (debt) and head products, Kotak Mahindra Asset Management Co. Ltd.

Sundaram Income Plus, an ultra short-term bond fund as per Value Research’s categorisation, has consistently had a higher expense ratio. As on December 2015, its expense ratio was 0.38%. Until then, it’s 6-month returns (a series of 6-month returns taken with quarterly frequency) and 1-year returns (a series of 1-year returns taken with quarterly frequency) were in the top quintile in the ultra short-term bond fund category. In 2016 and 2017, its expense ratio shot up to 2.25% as on December 2016 and 2.19% as on March 2017. Its returns fell in this period; on both the 6-monthly basis and 1-yearly basis, its returns now lie in the bottom quintiles.

In an emailed response, Sundaram Asset Management Co. Ltd said that Sundaram Income Plus “cannot be compared within the generic ultra short term category as it is an entirely different kind of fund that takes a little bit higher credit risk to deliver better returns. The correct fund to compare in the ultra short-term category is ‘Sundaram Ultra Short Term Fund (SUSTF)’. SUSTF is a plain-vanilla ultra short-term bond fund and it does not take duration or credit calls. In our analysis, this fund’s expense ratio figures are among the highest in the category.

It’s 6-monthly and 1-yearly performance has consistently been in the bottom quintiles over the past 2 years.

That said, a higher expense ratio need not always be bad. Schemes like Franklin India Short-Term Income Plan (FISTIP) and HDFC Regular Savings Fund have consistently had among the highest expense ratios in short-term bond funds, and yet they have delivered top quintile returns, again consistently. “It is our endeavour to deliver competitive performance over medium- to long-term in line with the scheme’s investment strategy. Expenses are determined based on various factors like Sebi regulations, nature and complexity of the product and competitive forces," says Anil Bamboli, senior fund manager–fixed income, HDFC Asset Management Co. Ltd.

Raju Sharma, head–fixed income, IDBI Asset Management Co. Ltd says that accrual- and duration-strategy funds tend to charge higher expense ratios than the rest. “In duration or accrual strategy, returns generated from the schemes tend to be higher, hence the high expense ratio. Lot of effort goes into construction of the portfolio, identification of securities for higher interest accrual, deciding the structure of the securities and collateral, etc."

This phenomenon can be seen particularly in the ultra short-term bond funds category. Take the case of May and June 2017. Sorting the 53 schemes in order of their expense ratios, we classified 17 schemes in the top quintile (schemes with least expense ratios) and 17 schemes in the bottom quintile (schemes with highest expense ratios). The average exposure that those with the highest expense ratios have to assets that are rated AA—and below—is 14.74%. On the contrary, the average exposure that those with the lowest expense ratios have to such assets is 9.91%. Some distributors point that as returns from traditional fixed income instruments have gone down, fund houses have worked towards wooing retail investors towards debt funds. “That is also one reason why expense ratios have been high in some funds. But this is a good move as investors too need to allocate their assets between equity as well as debt funds," says one of Bengaluru’s biggest mutual fund advisers. Debt fund folios in the retail segment grew from 6.75 million in December 2015 to 7.94 million in December 2016—or by around 18%—the highest year-on-year growth since the year of 2011.

Jiju Vidhyadharan, senior director, funds and fixed income business at Crisil Research points out to an internal study, which said that funds with high expense ratios have done well on a consistent basis. “A high expense ratio need not necessarily result in subdued performance. While a higher expense ratio would have a bearing on the net returns of the fund for the investor, the performance of the fund also depends on fund management. In case of debt funds, duration and credit management of the underlying portfolio plays an important role in fund management."

Should you then ignore expense ratio? “Expense ratio is a part of the due diligence study of investors, but in terms of importance it should rank subsequent to hygiene factors like the fund house’s pedigree, scheme’s size, fund manager track record and performance. When performance is considered, expense ratio is automatically taken care of, because the NAV (net asset value) is declared post expense ratio. The investor should not take a naive and straightforward view that low expense ratio is better per se. Expense ratio matters more in plain-vanilla defensive funds. To take an analogy, an A-lister star in Bollywood may charge Rs3 crore to the producer but the film may do business of Rs100 crore whereas a B-lister actor may charge Rs50 lakh but the film may rake in Rs30 crore. It is more important for the investor to understand where the performance alpha is coming from: is it because of credit or duration calls and whether she is comfortable with the strategy. If she is convinced of the fund philosophy and has appetite for that risk, high expense should not be a deterrent. In the earlier analogy, if the producer is convinced of the saleability of the star, high charges would not stop him," says Joydeep Sen, managing partner, Sen & Apte Consulting Services LLP, a wealth management firm that specializes in mutual funds and bonds.

Therefore, take a good look at expense ratios, but don’t treat them in isolation.

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Published: 08 Aug 2017, 04:39 PM IST
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